European banks, rattled by investor uncertainty about their ability to withstand a sovereign-debt crisis, are poised to win a reprieve in Basel, Switzerland, this week as regulators from 27 countries shape new capital rules.
A push to water down stringent standards proposed last year by the Basel Committee on Banking Supervision, and to allow more time to implement them, is led by France and Germany, according to bankers, regulators and lobbyists involved in the talks. Representatives from the U.S. and the U.K., who have sought to rein in risk-taking, are willing to compromise on how capital is defined to reach an agreement at a committee meeting that begins tomorrow, the people said.
Another concession may involve granting transition periods of up to 10 years to ease concerns of some member countries that their banks and economies won’t be able to bear the burden of tougher capital requirements until a recovery takes hold. As a result, the amount of capital European banks will be forced to raise in the next two years won’t be as much as investors fear.
“Politicians in France and Germany are worried about the impact of the rules on their economies,” said Chris Bates, a regulatory lawyer at Clifford Chance LLP in London. “Basel has managed to bring diverging banking systems and economies together. It’s more than just a capital regime. It’s a showcase of global cooperation. So the U.S. and the U.K. cannot let it break down.”
The 36-year-old Basel committee, a body of central bankers and regulators that sets capital standards for banks worldwide, was asked by the Group of 20 nations to draft new rules after the worst financial crisis in 70 years caused lenders to write off $1.8 trillion. G-20 leaders urged the committee to improve the quantity and quality of bank capital, strengthen liquidity requirements and discourage excessive leverage. They set a deadline of December for making the rules and originally gave countries until the end of 2012 to implement them.
Three months ago, European leaders and finance ministers, including those from Germany and France, were as adamant as their American and British counterparts in pushing back against banks’ objections to proposed rules that UBS AG estimated could force banks to raise $375 billion of capital, according to the regulators and bankers, who asked not to be identified because they weren’t authorized to speak. Fifty-five percent of that would have to be raised by European banks, UBS said.
Then Greece’s debt woes unnerved investors, making European leaders more receptive to what the banks were saying, according to the people.
At their meeting in Toronto last month, G-20 leaders hinted at delays. While continuing to urge stricter capital and liquidity standards, they said implementation could take economic conditions of member states into account.
“The challenge of the eurozone crisis clearly played into the Toronto document,” said Barbara Matthews, a former bank lobbyist and now managing director of BCM International Regulatory Analytics LLC in Washington. “It gave wiggle room on implementation.”
Even if they’re softened and delayed, the new capital rules, known as Basel III, will force banks to take fewer risks and be better capitalized, said Paul Miller, an analyst for FBR Capital Markets Corp. based in Arlington, Virginia.
“There’s a misperception out there that Basel III isn’t going to happen, or if it does it will be so watered down it won’t matter,” Miller said. “Even with the tweaks in the next few months, they’ll come up with a pretty strong framework.”
Fixing Basel II
The Basel III proposal attempts to fix the shortcomings of an earlier revision, known as Basel II, which was initiated by lenders in the late 1990s and lowered capital requirements by as much as 29 percent for some banks. The new rules would tighten control of what goes into the banks’ calculation of risk, redefine what counts as capital and impose higher charges against holdings such as derivatives.
The committee is expected to decide on the definition of capital this week and defer issues such as capital ratios until its meetings in September and October, according to members.
One part of the definition would exclude minority interests that banks hold in other financial institutions when calculating common equity on the theory that they can’t readily withdraw the capital. Many European lenders, which have lobbied against the rule, have non-controlling stakes in emerging-market banks that would no longer count as the highest level of capital, while the assets of the subsidiaries would have to be included in the banks’ risks.
BNP Paribas, HSBC
The change would have the largest impact on European lenders of all the proposed capital rules, UBS said in a March report. BNP Paribas SA, France’s largest bank by assets, would see its capital lowered by $10.7 billion, more than any lender, if it couldn’t count minority interests, analysts at JPMorgan Chase & Co. wrote in February. London-based HSBC Holdings Plc would have its capital reduced by $6.9 billion, and Societe Generale SA, the third-biggest French bank, $4.7 billion.
European banks are likely to win a concession on the minority-stakes rule, according to the people involved in the talks. One possible compromise would allow a bank to count part of its stake in relation to the risk the capital is supposed to cover at the entity in which it invested, the people say.
The fight over whether to count minority stakes comes as the Basel committee is trying to counter an attack by bankers who have said that harsh rules come with costs. Investors will pay with lower returns from owning securities in their firms, and Main Street will suffer as economic growth and lending slow and fewer jobs are created, bankers say.
A study released in June by the Institute of International Finance, which represents more than 375 financial companies, said the regulations could erase 3.1 percent of gross domestic product in the U.S., the euro region and Japan by 2015. About 9.7 million fewer jobs could be created over the five-year period than would otherwise be the case, the IIF said.
Regulation is “never free,” said Bank of New York Mellon Corp. Chief Executive Officer Robert Kelly, who visited London and Brussels in June to meet lawmakers and regulators with the Financial Services Roundtable, a Washington-based industry group. “There has to be some impact on growth and jobs.”
The Basel committee, whose members have touted the benefits of financial stability, is preparing its own economic impact study with the help of the Bank for International Settlements in Basel and the International Monetary Fund.
“Preliminary results do not point to a growth problem coming from the regulation,” Jaime Caruana, general manager of the BIS, said in Basel on June 28. “On the contrary, it would support resilience relatively rapidly.”
The Basel committee may publish the study later this month or in August, according to a person with knowledge of the matter. The report is expected to show an impact on economic growth of about one-third what the IIF calculated, another person familiar with the research said.
U.S. regulators also have been dubious about the banks’ analysis. The Federal Reserve, which is collecting data from banks for a separate impact study, has rejected some of the lenders’ assumptions and asked for changes, according to people familiar with the discussions.
The Basel committee plans to announce its rules by the time G-20 leaders gather in Seoul in November. In addition to defining capital, the group needs to determine three ratios before then: one on common equity as a percentage of risk- weighted assets; one involving Tier 1 capital, which includes securities that could help a lender cover unexpected losses; and one on Tier 2 capital, which incorporates a broader range of securities that would protect depositors and creditors in case of insolvency.
Banks currently need to hold capital equal to a minimum of 8 percent of risk-weighted assets. Half of that must be Tier 1 and half of the Tier 1 needs to be common stock. The Basel committee might triple the common ratio requirement and double Tier 1, FBR’s Miller estimates.
How the committee defines what counts as capital is as important as what the ratios are. In addition to the fight over whether to exclude minority stakes, there is a debate over deferred tax assets, past losses that lenders use to offset tax charges in future years.
The proposed Basel rules would prevent banks from counting these assets as part of their core capital. Japanese banks, which rely on deferred tax assets more than their counterparts in Europe and the U.S., are leading the campaign to block the exclusion, according to people involved in the talks. While the proposal might not change, the Basel committee may accept a phase-in period of between 5 and 10 years, the people say.
The committee may also relax the implementation of other rules by giving national regulators two years from the beginning of 2012 to come up with plans to put the regulations into effect, the people involved in the discussions say. Each part of the proposal might have its own time horizon.
Final versions of some Basel rules, including new liquidity requirements for how much cash banks need to hold, may not be agreed upon before the November G-20 meeting.
A liquidity coverage ratio is designed to ensure that all of a bank’s liabilities coming due in a month can be paid with cash and other assets, such as Treasuries, that can be sold easily for cash. A net stable funding ratio extends the same concept to a year, incorporating other holdings, such as short- term loans and stocks. Banks objected to the long-term rule, which could result in new debt issuance of $5.4 trillion, Barclays Plc analysts estimated in June.
The target date for publishing the rule may be pushed back to the middle of next year, four committee members said.
Another source of disagreement between European and U.S. regulators is a change that would increase capital charges on banks to cover counterparty credit risk, or the likelihood of trading partners going bust, the people said.
That portion of Basel III would create a buffer against the kind of danger posed by American International Group Inc. during the credit crisis. U.S. and European banks thought they had hedged their mortgage investments through derivatives contracts with AIG, which couldn’t keep up with increased cash demands as the values of the bonds declined. The U.S. government bailed out the insurer, concerned that its collapse would bring down banks that bought the derivatives.
The Basel committee probably won’t make a decision about counterparty risk this week, deferring the issue until October, members say. At least one said he expected the matter will be delayed to next year.
Issues that can’t be resolved by the Basel committee may be settled by the G-20 leaders in November, members say.
“The regulatory space has been far more politicized than I’ve ever seen it,” said BCM’s Matthews, who has been involved with Basel rulemaking for two decades. “Heads of state care, have opinions and are aware of decisions at very granular levels.”
One proposal European banks and regulators tried to get rid of -- and that U.S. Treasury Secretary Timothy F. Geithner advocated -- has survived and made it into the Toronto G-20 statement. That’s a plan to cap bank leverage by setting a ratio of assets to capital. While current Basel rules allow banks to assign weights to assets based on their risks, the leverage ratio would look at all assets without a risk assessment.
European banks appear more highly levered than their U.S. counterparts partly because U.S. accounting rules allow more assets to be kept off balance sheets than European standards do. The two systems differ on which types of securitizations are included on the books and how derivatives contracts are netted.
As envisioned in the Basel proposal, the leverage ratio will initially be used to provide guidance to national regulators in their assessments of banks’ soundness. Only later, after accounting differences between countries are resolved, would it become a requirement.
BNY Mellon’s Kelly said the original Basel proposals would have forced some banks’ return on equity, a measure of profitability, to mid-single digits.
“If that was true, then they effectively become government utilities, because you couldn’t really raise capital in the private markets after that,” he said.
Bankers worried about maintaining existing returns may be missing the point, according to Basel committee Chairman Nout Wellink, who is also president of the Dutch central bank. The purpose of the new rules is to change the business model of banks, he said at an IIF meeting in Vienna last month.
“More stable, less leveraged banks would raise average ratings, improve the terms on which banks could raise funds, and lower the required return on equity,” Wellink said.
That view was reinforced in the Bank for International Settlements’ latest annual report, published June 28.
“High shareholder returns in the sector were unsustainable because they were generated by high leverage and risk-taking that proved to be unmanageable in a period of stress,” the report said. “Lower returns on equity could actually be a desirable outcome for the long-term investor as well as for the economy at large.”