It used to be a topic for banking specialists only. But when banks collapsed spectacularly and since the worldwide financial crisis, a broader public also became aware of it: Basel III. The question of how much money European banks must put aside to cover the risks of their different business activities is not only pivotal to the banking industry. Banking regulation is also the adjusting screw, to control the costs of banks' granting of loans to the real economy. Since 80% of the economy in the EU is partly or entirely financed by loans, growth in Europe depends on the banks' performance. The banking rules currently in force have now been tightened. In April 2013, the European Parliament formally adopted the outcome of almost one year of negotiations with EU Member States. The new set of rules is the most comprehensive and most far-reaching banking regulation in the history of the EU.
What are "Basel" and "CRD"?
The Basel Committee for Banking Supervision develops international standards for banks. Those standards used to be recommendations only. In 2006, however, with the so-called Capital Requirements Directive (CRD), the EU introduced binding Basel standards for the first time. The directive has since then been revised several times.
After the experiences of the worldwide financial crisis, the Basel Committee tightened its standards in September 2010. The so-called "Basel III" set of rules requires banks to own more equity capital, to be more resilient in crisis situations. Already in September 2009, the G20 summit in Pittsburgh agreed that the Basel rules would be introduced as binding law by G20 countries by 2013. "CRD4"- the latest set of capital requirements - is actually the implementation of 'Basel III' into EU law.
What is the state of play?
All major industrial countries committed themselves to introducing Basel III by January 2013. No country was able to keep up with this schedule. Europe is the continent where preparations are the farthest advanced. In the summer of 2011, the European Commission presented the draft "CRD4" law, which runs to over a thousand pages. In May 2012, the European Parliament agreed internally on its position and started negotiations with EU Member States. A political agreement was finally found in a late-night negotiation breakthrough in February 2013. The legislative text was formally approved by the Council on 27 March. Parliament adopted the new law on 16 April 2013. Most of its provisions will enter into force on 1 January 2014.
What does "CRD4" regulate?
"CRD4" addresses questions like: how much money must European banks put aside to cover the risks of different business activities? What kinds of businesses bear how much risk? Is lending money to a small or medium-sized enterprise (SME) really more risky than lending to a state? How can we avoid a credit crunch and finance growth in the EU? What incentives are there for bankers to take risks? Are Member States allowed to add additional rules to the common CRD4 set of rules?
What did the European Parliament achieve?
The Economic and Monetary Affairs Committee of the European Parliament decided in May 2012 on Parliament's position in the negotiations with the Council. Unusually, the decision was unanimous across all major parties in the Parliament. This was a great success for EPP Group member and Vice-President of the European Parliament Othmar Karas, who is Rapporteur - i.e. the Parliament's negotiator - on CRD4. Parliament has pushed strongly for the following points:
- European banks must hold more and better capital in the future. This makes banks more resilient in crisis situations and avoids taxpayers' money being used to prop banks up.
- The security buffers of the banks have to become more 'liquid'. In stress situations, banks have to be able to fulfil all their liabilities for at least 30 days.
- The new set of rules has to better take into account the specifics of the European banking sector. Continental European banks, often more oriented towards retail banking, must not be disadvantaged compared to Anglo-American competitors, who are often more oriented towards investment banking.
- Banks must focus on their core business, which is financing the real economy. Loans to SMEs and business start-ups will be made easier.
- European banks have to publish, country by country, what their profit is, how much tax they pay and how much they receive in subsidies. This increases transparency.
- Member States cannot simply add additional, stricter rules for their banks, but must get additional rules approved at EU level.
- Bankers' bonuses will be capped. This is to avoid the wrong kind of motivation for managers.
Parliament managed to get all these points through in the negotiations with EU Member States.
How exactly does CRD4 stabilise the banking sector?
More and better capital: at present, banks have to hold a minimum total capital of 8% of risk-weighted assets. This minimum includes capital of different quality: 2% has to be core capital of the best quality. CRD4 will oblige banks to continue to hold 8% of minimum capital, but the share of core capital that has to be of the best quality will be increased to 4.5%. Moreover, banks will have to build up two additional capital buffers: 2.5% of best-quality capital is to be held as a conservation buffer and up to 2.5% as a so called countercyclical buffer. The countercyclical buffer is to be set by national regulators. Furthermore, systemically important financial institutions ('SIFIS') have to hold an additional 1 to 3% of best-quality capital. Also, for broader macroeconomic or systemic risks, Member States may under certain conditions require additional buffers. All these different changes increase the resilience of the banks in crisis situations.
More liquidity: the financial crisis was a liquidity crisis. It is not enough to hold more capital if it is not available in crisis situations or only with high costs. This is why two new criteria for liquidity are being introduced: the liquidity coverage ratio and the net stable funding ratio may not exceed a certain limit. Banks have to be able to fulfil their liabilities in stress situations for a period of at least 30 days. So far this has not been regulated at all.
How does CRD4 support growth and employment?
Balancing factor to facilitate SME loans: backing an SME loan with 75% of risk-weighted assets, but a Greek bond with 0% does not correspond to economic reality any more. This is why the European Parliament wanted to reduce the SME loan risk ratio by about a third through a balancing factor. The existing ratio of 75% will be decreased to about 50%.
SME balancing factor also for business start-ups: in order to support business start-ups, innovation and certain national new business programmes, the SME balancing factor shall be applied for such loans as well.
Raising the retail threshold from 1 to 1.5 million Euro: the definition of retail loans will be changed. So far, the risk ratio of 75% was limited to loans up to 1 million Euro. Parliament intends to raise this threshold to 1.5 million Euro. In doing this, more loans will fall under the above-mentioned new rules.
Export and trade funding: for certain export and trade funding the risk ratio is to be lowered as well.
How does CRD4 provide more fair play in the banking sector?
Manager bonuses: a bank manager's value shall be primarily expressed by salary. If additional bonuses exceed the salary by far the motivation structure of bank employees is distorted. The ratio between additional bonus and fixed salary shall normally be 1:1. In exceptional cases bank shareholders can allow bankers' variable remuneration to rise to twice the fixed salary.
Equal market conditions for all banks in the EU: continental-European banks must not be disadvantaged as compared to Anglo-American competitors. That is why the following characteristics of European banks are being recognized by CRD4:
- Cross-guarantee schemes and loss-sharing agreements will be recognized.
- Decentralized banks will be recognized: shares in the decentralized structure are not considered as loans.
- 'Substance over form': bank capital is to be rated by the criteria of substantial quality and loss capability but not by formal criteria such as legal form.