Basel II and the Capital Requirements Directives

Rules on capital requirements are designed to protect savers and investors from the risk of the failure or bankruptcy of banks. They ensure that these institutions hold a minimum amount of capital. The Capital Requirements Directives were adopted in 2006 and are currently under review.

Background

Capital adequacy rules set down the amount of capital a bank or credit institution (CI) must hold. This amount is based on risk

There are all sorts of financial instruments available by which credit institutions can guard against risk (risk mitigation), such as derivatives, futures, corporate bonds and asset-backed securities.

The rules are enforced by supervisors who check on how much risk is being run (risk weighting) and gauge how much capital is required to underwrite (insure) that risk. Once each bank has been assessed by the supervisors it is given a “risk profile”. 

Internationally, rules are set by the Basel committee, part of the Bank for International Settlements (BIS). On this committee sit representatives from Belgium, France, Germany, Italy, Luxembourg, Netherlands, Spain, Sweden, Switzerland, UK, Canada, Japan and US. The first set of international rules was known as Basel I.

In June 2004, the Basel committee agreed updated rules - Basel II. These had to be applied in the EU and in July 2004, the Commission set out proposals for a new Capital Requirements Directive (CRD) which would apply Basel II to all banks, CIs and investment firms in the EU. 

The current EU regime is contained in two directives: Directive 2006/48/EC on the “taking up and pursuit of the business of credit institutions” and Directive 2006/49/EC on the “capital adequacy of investment firms and credit institutions”.

The European Commission in October 2008 presented a review of the rules in place. The proposed changes request banks to hold a higher amount of capital against the risk of failure and introduce a new coordinated, although cumbersome, supervisory process for cross-border EU banks (EURACTIV 02/10/08). According to EU official figures, in October 2008 there were in Europe 44 cross-border institutes, holding two thirds of total EU bank assets.

The proposal has been agreed by the European Parliament in May 2009 (EURACTIV 07/05/09) and later by the Council. Even before the vote in the Parliament, the Commission proposed a new review of the directives to take into account risks related to trade books, securitisation and managers' remunerations (EURACTIV 29/04/09). The unusual move reflected the particular conditions of international financial markets hit by the worst crisis since the '30s.

While the initiative still waits for a green light from member states, the Council has proposed tougher rules for granting loans in periods of economic growth, in order to allow banks to have higher "liquidity buffers" in new crisis.

Issues

Three main issues raised when current rules were proposed:

  • more risk sensitive;
  • costs to smaller banks and consequently to small-company growth, where the EU lags other regions, and;
  • moral hazard concerns in that risks are partly passed to insurers and banks, unlike insurers have potential last resort support from central banks.

1. Risk sensitive

The scheme is more risk-sensitive than the previous one applied and sets rules for:

  • Three different levels from which institutions can choose (Pillar 1): standard, foundation and advanced; 
  • supervisory review process (Pillar 2): CIs do an internal assessment which is then checked by supervisors and the minimum required amount of capital is set (capital charge);
  • public disclosure (Pillar 3): CIs must make certain information public to allow the market to judge their risk worthiness and react accordingly (market discipline);
  • single market passport: mutual recognition system allowing banks and CIs to operate throughout the EU once approved by their own national regulatory authority, and;
  • consolidating supervisor: a new national banking supervisory body responsible for cross-border issues. It must ensure harmonisation across the single market.

2. SMEs and smaller banks

There are concerns over the costs to smaller banks. Also, SMEs fear that, under Basel II, banks will be reluctant to lend money to what are seen as higher-risk ventures or will only lend at higher rates. The proposed solutions are lower charges for lending to SMEs and an increase in the types of collateral that can be used for loans. A specially commissioned report done by PriceWaterhouseCooper showed overall benefit for the SME sector.

 

3. Shifting risk

Some commentators argue that strengthening the capital base of banks and encouraging the management of risk does not do away with the risk but merely passes it on elsewhere. Credit risk in particular is being passed on to insurance companies and funds, which are in turn passing it on to householders. The International Monetary Fund has produced a study which asks whether ultimately, it may be the consumer who stands to lose if things go wrong.

The directive seeks to bring supervisory practices among member states broadly into line and to enhance co-operation between supervisors. Specifically, it creates a “consolidated supervisor” for banking groups which operate across-border. 

The EU Committee of Banking Supervisors (CEBS) has a key role in ensuring consistency among national supervisors, although it does not have an overall regulatory role. 

The directive allows member states to choose between regulatory options in some areas (around 140). Some commentators support this flexibility while others view national discretions as per se a bad idea (they raise costs, cause competition problems).

Positions

Eurochambres, Eurocommerce and UEAMPE are concerned about the impact of the proposals on SMEs. They fear that the cost of implementing Basel II will hit smaller banks very hard. Such costs would then inevitably be passed on to SME borrowers who get much of their finance from smaller banks. 

The European Savings Bank Group (ESBG) welcomed the directive’s risk-sensitive approach and the retention of flexibility through national discretions on issues such as commercial mortgages. 

The European Financial Service Round Table believes that a lead (consolidating) supervisor should be given full powers to supervise all cross-border matters over and above the local supervisors. This would remove the need for multiple reporting, reducing costs and creating certainty. They advise that this be done by means of an EU directive, setting out a legal framework of powers and duties. 

Timeline

  • June 2006: Capital Requirement Directives adopted
  • January 2007: The Directive came into force
  • October 2008: The European Commission proposed a review of the Capital Requirement Directives
  • April 2009: The European Commission proposed a new review of the Capital Requirement Directives to take into account risks related to trade books, securitisation and managers' remunerations
  • May 2009: The European Parliament adopted the 2008 review of the Capital Requirement Directives

Further Reading