Banking regulation in Europe: where do we stand?

Summary:

– The Basel III reforms were necessary and introduce new elements that should increase the resilience of the banking system.

– However, they do not promote market discipline and their timetable seems rather restrictive in the current climate, at the risk of delaying the economic recovery.

– CRD4 seeks to strengthen microprudential standards, drawing on the expertise of both the European Banking Authority and national regulators.

– The capping and regulation of salaries in the banking system, particularly bonuses, will become official in 2014.

On March 4, the members of the Eurogroup, made up of the finance ministers of the European Union countries, met to discuss the European strategy to be adopted in the context of the implementation of the Basel III standards. The objective of this meeting was very clear: to tighten banking regulations by finding a compromise for the CRD4 directive.

Since the beginning of the subprime crisis in 2007, banking regulation has been a major topic of economic debate and has regularly undergone numerous twists and turns. Successive agreements have been reached to strengthen the Basel II measures and thus move on to Basel III: commissions have been set up (de Larosière, Vickers, Liikanen), new regulatory institutions have been created or replaced (European Banking Authority (EBA), European Systemic Risk Board (ESRB), Single Supervisory Mechanism[2](SSM). These contributions should help to establish a robust framework to ensure financial and banking stability in the future.

Currently, three major issues are emerging and are under review: the implementation of Basel III and the additional requirements imposed on SIFIs, the scope of action of the EBA and national regulators , and the regulation of bonuses in the financial sector. What is the reality of the situation and what is the scope of these measures?

The new Basel III measures

Given the scale of the crisis and the ineffectiveness of the Basel II measures, the Basel Committee had to adopt new reforms to ensure the resilience of the banking system for years to come. With the introduction of the new Basel III standards, the objectives are to increase the quality of banks’ capital, improve risk coverage, introduce more countercyclical measures, and integrate a prudential approach aimed at incorporating the systemic dimension of certain banks.

For the European Union (EU), Basel III came into force on^{January 1}, 2013, and should be fully implemented by 2019. Banks are expected to adjust to these regulations in stages. The initial timetable has been revised, with some flexibility to allow banks to gradually converge towards the new standards, and will be revised again depending on the ability of banks and, above all, the economy to emerge from the crisis.

Capital requirements have therefore been revised upwards since Basel II:

– The Tier One capital ratio (T1), which is the ratio of a financial institution’s core capital to its total risk-weighted assets, is one of the most important ratios in the Basel Committee’s new framework. It is set to rise from 4% (under Basel II) to 6%. This type of capital is considered to be of higher quality, and therefore more expensive for banks, but should enable them to avoid losses while mitigating the problems associated with excessive debt.

Other ratios, such as Common Equity[4]or total capital, will reach 4.5% and 8% of total risk-weighted assets, respectively.

– Short- and long-term liquidity ratios, meanwhile, seem rather redundant (given the ratios presented above) and highly pro-cyclical, while allowing for the segmentation of asset markets based on the number of assets eligible for these ratios. These measures apply to all banks, with SIFIs facing higher requirements (between 1% and 2.5% per ratio, depending on the size of the systemic banks).

The implications of this regulation: greater counter-cyclicality and better management of systemic risk.

To cope with tighter financial conditions and combat the procyclicality of certain ratios, countercyclical buffers have been included so that the above ratios, excluding liquidity ratios, can be increased by up to 2.5% for each bank. During periods of growth, banks will have to build up additional capital reserves that can be mobilized in times of crisis, when the buffers will be reduced to 0%. Another important contribution of Basel III is the introduction in 2013, on a trial basis, of a leverage ratio[5](ratio of capital to total unweighted assets) that would amount to 3% of T1.

Overall, the methods for calculating the level to be achieved for each ratio have been revised, with a particular focus on improving the measurement of « extreme » risks. These risks, which are very unlikely to materialize but have uncertain financial consequences, will therefore be incorporated through short-term stress scenario simulations and specific tools. In addition, the introduction of the leverage ratio, mentioned above, should make it possible to circumvent the difficulties associated with the complexity of banks’ internal models, which have tended to underestimate the risks associated with certain asset classes.

The introduction of new standards appears necessary in order to move towards banking regulations that are more appropriate than those under Basel II. However, according to some economists, these new ratios could have potentially prevented the 2007-2009 crisis, but there is no guarantee that they will be robust enough to prevent or even avert a future crisis, given that they were introduced as an ex post reaction . The introduction of countercyclical instruments could potentially fill this gap, as they have the advantage of looking further ahead and thus providing ex ante leeway.

With regard to systemic risk, despite specific measures for SIFIs, the Basel Committee’s approach remains insufficient because it does not include enough incentives to compel institutions to self-regulate by introducing greater market discipline.

In the current situation, where activity has not resumed and the crisis continues, requiring banks to step up their efforts to converge towards Basel III may prove to be a double-edged strategy for growth. This type of criticism is often voiced within the banking community, where lobbyists argue that higher requirements would inevitably lead to credit rationing. Indeed, according to the latest figures from the Bank Lending Survey[8] in Europe, the supply of credit from banks is generally not meeting the needs of the real economy. Basel III may be too much and could contribute to this « slowdown » in the recovery, but it is by no means the only cause.

Standards under CRD4 and the power of the EBA

The CRD4 provisions on banking regulation are based on those adopted by Basel III and aim to go even further. European countries have agreed to allow themselves some leeway so that each can increase prudential standards by up to a maximum of 5% of additional capital, depending on the degree of stability of the financial system.

These potential increases will mainly apply to large, systemically important banks, of which there are 15 in Europe and 29 worldwide. However, it should be noted that all banks are capable of generating systemic risk, regardless of their size, so it seems plausible that increased prudential requirements should apply to all banks.

If a country wishes to regulate its banks more strictly, it must first obtain the agreement of the EBA and the European Commission in order to preserve the integrity of the single market in Europe and thus avoid the emergence of national approaches to banking regulation in favor of a global and European vision.

The EBA, the central body responsible for ensuring financial stability in Europe, which took over from the Committee of European Banking Supervisors in November 2010, will therefore see its role strengthened with CRD4. It does not act as a direct supervisor of banks but is responsible for standardizing prudential rules among national regulators and monitoring their actions. However, it is not completely uninvolved in the supervisory process, as it will cooperate with the Single European Supervisory Mechanism (a new ECB service), which will be responsible for monitoring compliance with prudential standards and organizing stress tests.

Cap on remuneration in the banking system

With regard to bonuses paid by EU banks (and their subsidiaries in third countries, as well as foreign banks established in Europe), new regulations will come into force in 2014 on remuneration in the financial sector, and more specifically on the size of bank bonuses. This means that the variable portion of the remuneration of any employee whose actions are likely to impact the risks borne by their bank may not exceed the fixed portion of their annual salary.

However, bonuses may be double the remuneration if shareholders are in favor of this. The exact rule stipulates that if 50% of shareholders are represented, 66% must vote in favor of a bonus worth double the annual salary for it to be approved. The only way to deviate from this rule is for banks to pay out nearly a quarter of their bonuses over a five-year period, with the possibility of canceling bonuses in the event of poor performance or losses (an appropriate measure that reinforces market discipline and could help fuel a safety net system facilitating the process of recapitalizing banks with internal resources in the event of a crisis). In this specific case, the variable portion (excluding bonuses) could be up to twice the fixed portion (which will only be effective in terms of market discipline if the risks taken to increase bonuses over five years are greater than those taken to increase premiums[10]).

Overall, this last point, concerning banks and remuneration caps, has received a very negative response from the financial community, which fears that it will force them to increase the fixed portion of their employees’ remuneration, a significant cost at a time of balance sheet adjustment. In order to ensure that banks apply and engage in this new salary framework, the European Commission will require a high degree of transparency from the banking sector. By 2015, all banks will be required to report their levels of public aid received, profits, and net turnover to the European Commission each year.

Conclusion

Regulation in Europe is on the right track and significant progress has been made on several levels. New measures are expected to be gradually implemented from 2014 onwards to strengthen the transparency, stability, and resilience of the banking system under the auspices of the ECB. However, several doubts remain about this increase in regulation: is it not a little premature, given both the current difficulties with the crisis and the very slow pace at which regulation is being established in the United States, and does it really include strong incentives to compel financial institutions to be more cautious and to self-regulate? Beyond these concerns, financial stability is a major long-term issue, and the measures currently being taken are part of this approach.