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.