EU Escalates Standoff With U.S. on Global Bank Capital Rules

  • 28-nation bloc objects to capital floors in risk measurement
  • Official says Basel overhaul shouldn’t boost EU banks’ burden

The European Union upped the ante in its battle with the U.S. over changes to global bank-capital rules, calling for a key plank of the reforms to be scrapped.

The EU, home to nearly half of the world’s biggest banks, opposes the introduction of capital floors, a restriction on firms’ use of their own statistical models to measure asset risk that would drive up their capital requirements, an EU official said. The U.S., by contrast, has said regulators should consider discarding the internal-model approach altogether because it creates the potential for banks to game the rules.

“It used to be Europe that criticized the U.S. for failing to implement the Basel accords properly, but now the positions seem to have flipped,” said Martien Lubberink, an associate professor at Victoria University of Wellington. “In one instance after another we’ve seen Europe trying to backtrack on capital requirements. The argument now seems to be to let the banks take on risk to boost earnings and build up capital.”

The Basel Committee is racing to finish work on the post-crisis capital framework known as Basel III by the end of the year, and it’s under instructions not to increase overall capital requirements significantly in the process. That promise, first made in January, left open the possibility that individual countries or banks could face a marked increase.

Stiffer Standards

The debate in Basel pits bank regulators from Tokyo to Frankfurt against a U.S.-backed push for stiffer standards, which take effect when they’re implemented by national governments. Regulators from countries including Germany and Italy told the Basel Committee in recent meetings that the proposed changes to how banks assess credit, market and operational risks must be scaled back and slowed down, according to two people with knowledge of the matter.

Stefan Ingves, chairman of the Basel Committee, downplayed the dispute over risk-weighed capital rules.

“This process has been going for about eight years,” he told reporters in Frankfurt on Friday.“By now all the issues are well understood. That’s not a problem in itself. Right now we’re working very hard to finalize this, and I hope that we’ll be able to do so toward the end of the year.”

Internal Models

Finding a compromise on capital floors, which would cap the benefit banks can gain by measuring asset risk using their own statistical models instead of a standardized formula set by regulators, may prove challenging.

For about the past decade, lenders have been allowed to use sophisticated models with supervisory approval. In theory, this should give them an incentive to invest in less risky assets and price them in line with risk. Yet supervisors’ practical experience and empirical research have fed suspicions that banks misuse it to understate risks and manage down their capital requirements. Floors would limit their ability to do so.

The European Commission, the EU’s executive arm, wants the floors removed from the Basel Committee’s final rules because they would undermine the sensitivity of risk-assessment tools and drive up capital requirements for the bloc’s banks, the official said.

Europe’s not alone. Shunsuke Shirakawa, vice commissioner for international affairs at Japan’s Financial Services Agency, said in June that the Basel Committee needs to “create a rule for each financial transaction that accurately reflects its risk,” providing an “incentive for banks to properly manage their risk.”

‘Common Sense’

Felipe Villarroel, a portfolio manager at TwentyFour Asset Management LLP, said the EU position is welcome for the safest firms. “Common sense looks to be prevailing,” he said. “We see no reason why their capital requirements should be higher.”

Those views are hard to square with objections made by Daniel Tarullo, a U.S. Federal Reserve governor, who said in 2014 that the “combined complexity and opacity of risk weights generated by each banking organization for purposes of its regulatory capital requirement create manifold risks of gaming, mistake, and monitoring difficulty.”

“The Basel Committee is between a rock and a hard place here,” said Richard Reid, a visiting professor at Cass Business School in London. “On the one hand, it’s keen to have in place a full set of stability-orientated policies on time. On the other hand, it doesn’t want to cause a fracturing of the hard-won coordination of regulation in the wake of the financial crisis.”

Excessive Variability

While the EU accepts that there can be excessive variability in capital requirements across banks and jurisdictions, that doesn’t indicate a one-size-fits-all solution, the official said. If real estate is less risky in one region, risk models should be allowed to reflect that, the official said.

Large European banks may be more vulnerable than their global peers to the changes Basel is considering for a number of reasons. Bank loans to companies are generally more relevant in Europe than in the U.S., where bonds dominate corporate borrowing. European banks keep mortgages on their books, while U.S. lenders offload them to government-sponsored entities such as Freddie Mac.

“The salience of the mortgage issue in northern Europe, and the differences among different national mortgage markets, are such that it’s reasonable to expect this to be an area in which the Basel Committee could end up compromising,” said Nicolas Veron, a senior fellow at the Bruegel think tank in Brussels. “That might divide the current anti-Basel coalition and might help preserve essential elements of the package.”

The EU also identifies the Basel Committee’s proposals on measuring operational risk as an area where more work is needed, since the new method yields somewhat arbitrary results, the official said. The regulator has proposed a single standardized method for assessing operational risk, the potential for losses from inadequate or failed internal processes, people and systems, including legal risks, and from external events.

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