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
EU official documents
- Eur-Lex:Proposal for Re-casting Directive 2000/12/EC relating to the taking up and pursuit of the business of credit institutions and Council Directive 93/6/EEC of 15 March 1993 on the capital adequacy of investment firms and credit institutions.(COM(2004)486) (14 July 2004) [FR] [FR] [DE]
- RAPID:Commission proposes new capital requirements for banks and investment firms(14th July 2004) [FR] [FR] [DE] [FR] [DE] FAQ
- RAPID:Capital adequacy: Commission welcomes significant progress on new Basel Capital Accord(11 July 2002) [FR] [FR] [DE]
- RAPID:Banking Supervision: reform of the capital adequacy framework frequently asked questions(23 Jan 2001)(Memo/01/15) [FR] [FR] [DE]
- RAPID:Commission welcomes Basel Committee's review of the impact of new Capital Accord(IP/01/1862) (19 Dec 2001) [FR] [FR] [DE]
- DG Internal Market:Study on consequences for SMEs, Price Waterhouse Cooper(Feb 2003)
- OEIL:Financial institutions: capital adequacy of investment firms and credit institutions
- Parliament:Report on capital adequacy by Alexander Radwan(4 April 2005 ) [FR] [FR] [DE]
- Rapid: Speech by Commissioner McCreevy:Managing financial institutions: the key challenges(21 June 2005)
International Organisations
- BIS:Bank for International Settlements:Basel II: International Convergence of Capital Measurement and Capital Standards: a Revised Framework(26 June 2004) [FR] [FR] [DE] [FR] [DE] Press Release
- BIS:Consensus achieved on Basel II proposals(11 May 2004)
- BIS:Basel Committee on Banking Supervision
- IMF:study by Gerd Hausler:Risk Transfer and the insurance industry
Business & Industry
- UEAPME:Basel II Directive made more positive for SMEs by Parliament Report(26 April 2005)
- European Banking Industry Committee:Position paper on the proposed capital requirements directive(24 March 2005)
- ESBG:Prudential supervision of banks: should the EU opt for the sledgehammer or the step-by-step approach?"(March 2005)
- FBE:Letter to Commissioner McCreevy on Consolidated supervision in the Capital Requirements Directive(25 Jan 2005)
- ESBG:ESBG supports ECOFIN Council's approach to new capital requirements framework(7 Dec 2004)
- FBE:Ecofin General Approach Welcome but Does Not Go Far Enough, says European Banking Federation(7 Dec 2004)
- UEAPME:SMEs still concerned about higher loan costs and less transparency(22 Nov 2004)
- UEAPME, Eurochambres, Eurocommerce:Review of the Capital Adequacy Directive: Position Paper of SME Associations(Nov 2004)
- FBE:The Basel Capital Accord and the Capital Requirements Directive(13 Sept 2004) Background summary
- ESBG:Response to CEB's Consultation Paper on the application of the Supervisory Review Process under Pillar II(31 Aug 2004)
- European Financial Services Round Table:On the lead supervisor model and the future of financial supervision in the EU(29 June 2005) Press Release
- World Saving Banks Institute (WSBI):Looking back - the achievements of 2005, looking forward - the challenges of 2006(April 2006)
NGOs and Think-Tanks
- CEPS:The New Capital Requirements Directive: what pieces are still missing from the puzzle?(Sept 2005)
- CEPS:Practical Implications of the New Basel Capital Accord for the European Banking System(12 Jan 2005)
- UK Financial Services Authority:Supervising financial services in an integrated European single Market(Jan 2005)
- UK Financial Services Authority:Strengthening capital standards(Jan 2005)
- CEPS:Effects Of The Capital Adequacy & Late Payment Directives On SMEs(30 Nov 2004)
- Centre for Economic Policy Research:Transparency, Risk Management and International Financial Fragility(20 Feb 2004) Press Release
- European Shadow Financial Regulatory CommitteeBank Supervisors’ Business: Risk Management or Systemic Stability?(12 May 2003)
Non-assigned links
- CEBS: Committee of European Banking Supervisors:Consultation Paper on the implementation of Pillar 2 of the revised Basel Accord ("Basel II") and the relevant provisions of the Capital Requirements Directive(24 May 2004) Press Release
- CEBS:Consultation paper on the supervisory review process under Pillar II(June 2005)
- CEBS:Consultation on a common European framework for supervisory disclosure(23 March 2005)
- CEBS:consultation paper on the guidelines for a common approach to the recognition of External Credit Assessment Institutions (ECAIs)(29 June 2005)
- CEBS:European banking supervisors reveal plans for digital reporting(30 June 2005)