The EU’s implementation of Basel III: A deeply flawed compromise

By all accounts, EU member countries have for months been debating how to implement the minimum bank capital standards agreed under Basel III. Their arguments have unfolded as the EU works to complete its fourth Capital Requirements Directive and its Capital Requirements Regulation (see Veron 2012).

Three issues have been contentious:

• Whether member countries should be permitted to enact minimum capital ratios considerably tougher (higher) than those specified under Basel III without approval of the EU;
• Whether the restrictions on what can be counted as high-quality capital under Basel III should be scrupulously adhered to in EU legislation; and
• Whether the Basel III deadlines for introducing an unweighted leverage requirement for bank capital and two new quantitative liquidity standards (the liquidity coverage ratio and the net stable funding ratio) should be mirrored in EU legislation.

Unfortunately, the decision of the finance ministers announced on 15 May 2012 reflected a compromise that set back the cause of reform, risking further instability for the banking system in Europe and the global economy generally. The European Parliament should demand significant changes before approving this very flawed measure.

It has been reported that in the debates, the UK, Sweden, and Spain, with the support of the ECB, favoured a “yes” on all three questions. For convenience, I call this position the Osborne View – named after perhaps its most ardent proponent, George Osborne (UK Chancellor of the Exchequer). Another group of EU countries, reportedly led by Germany and France, with the support of the European Commission, opposed that position. I call this position the Schäuble View in honour of Germany’s Minister of Finance, Wolfgang Schäuble.

The 15 May compromise at a meeting of EU finance ministers was endorsed unanimously by the Council. Not all the details have been published, but the main features can be summarised as follows.

• Measured against banks’ total exposure, EU members will need EU approval to implement in their national banking legislation minimum (risk-weighted) bank capital ratios that exceed the Basel III minimum by more than 300 basis points.
• For domestic and non-EU exposure, the threshold for EU approval will be higher, at 500 basis points.

These thresholds would allow the UK to implement the recommendations of the Independent Commission on Banking (the Vickers Report) – including the ringfencing retail banking operations and a minimum equity capital ratio of 10%, without EU approval.

• The 15 May accord also permits EU banks to count as equity capital several financial instruments with dubious loss-absorbency, including the so-called “silent participations” of German banks and the minority stakes of French banks in insurance companies.

Such a step weakens the Basel III guidelines on the quality of bank capital. In one of the few concessions to the Osborne View, the agreement adheres to the Basel III time schedules for the leverage ratio and the two liquidity standards. Finally, to provide additional macro-prudential tools against asset-price bubbles in real estate, member countries will be allowed to modify (increase) the bank capital risk-weights against exposures to residential and commercial property.

Over the next few weeks, the European Parliament will discuss these steps and negotiate a final version with EU finance ministers. There are reports that the European Parliament may demand restrictions on bonus payments (in bank compensation policies) before approving the package, however.

Evaluation of the 15 May decisions

From a narrow procedural perspective, the 15 May ECOFIN decision is a step forward on financial sector reform. After all, the Basel III bank capital standards cannot go into effect until they are embedded in national banking legislation and the 15 May ECOFIN decision advances their implementation.

But fundamentally the 15 May decision is a setback for reform.

Basel III’s main purpose was to enhance financial stability and to limit the liability of taxpayers for bank losses by putting much more high-quality bank capital into banking systems around the world. The 15 May decision makes that harder in two ways.

• Requiring EU countries to win approval of the EU for minimum capital ratios much in excess of the modest standards in Basel III will discourage urgently needed strong capitalisation (and recapitalisation) of banks in the Eurozone.
• Watering down the Basel III standards for the quality of bank capital may encourage a race to the bottom on the loss-absorbency of bank capital. Such a development would weaken limits on taxpayer liability for bank losses.

I base my conclusion on five main points that I address in turn.

EU banks are undercapitalised

First, EU banks remain undercapitalised when evaluated by the appropriate metrics. The most reliable metric of capital adequacy – warts and all – is the simple unweighted leverage ratio (the ratio of equity to total assets). All the risk-weighted measures of bank capital have been distorted by political pressures, conflicts of interests, and gaming of the regulations by banks (Helwig, 2010, Admati et al, 2011).

Exhibit A: with all the questions about debt sustainability in some EU periphery countries, the sovereign debt of EU countries still receives a zero risk weight for the purpose of calculating risk-weighted assets, the denominator in all risk-weighted capital ratios. Experience in the run-up to the global economic and financial crisis of 2007-2009 also demonstrated the poor quality of risk-weight calculations for banks’ trading assets, securitised instruments, credit ratings of complex financial instruments, and the estimation of risk-weighted assets in banks’ internal models (Goldstein, 2012).

For this reason alone, the stress tests conducted by the European Banking Authority (EBA), which focus on risk-weighted capital ratios, ought to be viewed skeptically. Indeed, concern over deficiencies of risk-weighted capital metrics led the authors of Basel III to include a minimum (unweighted) leverage ratio over the objection of the banking industry.

The April 2012 Global Financial Stability Review reports that the leverage ratio (the ratio of Tier 1 common capital to adjusted tangible assets) for EZ banks in 2011 was a little more than 4% – versus about 5% for UK banks and roughly 6.5% for US banks (IMF, 2012a).[1]

Other measures of bank fragility point to the weakness of EU banks.

• The IMF (2011) estimated that between end-2009 and August 2011, EZ banks had a €200 billion increase in credit risk associated with holdings of the stressed sovereign debt of Greece, Ireland, Portugal, Belgium, Italy, and Spain.
• Inter-bank exposures to these countries brought the increase in credit risk to €300 billion.

No wonder that IMF Chief Christine Lagarde, speaking in August 2011, emphasised the urgent need for recapitalisation of EU banks (Lagarde 2011).[2]

EZ banks also rely more heavily on wholesale financing than US or UK banks, with loan-to-deposit ratios hovering at 125 – versus 105 for UK banks and less than 80 for US banks. The vulnerability of relying on wholesale funding was of course dramatically underlined in the second half of 2011, when wholesale funding strains for European banks compelled the ECB to launch its three-year Long-Term Refinancing Operation (LTRO) – a two-stage rescue effort that has risen to more than a trillion euros.

While necessary to prevent large-scale liquidity problems from generating massive deleveraging and exacerbating solvency concerns, the LTRO has produced undesirable side effects.

• It has facilitated a carry trade on peripheral sovereign debt that has led banks in those countries to load up even more sovereign debt, aggravating the adverse feedback loop between bank debt and sovereign debt.
• In addition, by tying up large amounts of collateral, the LTRO has further imperiled the position of unsecured bank creditors in the medium term. Spanish banks alone have enormous exposures to real estate.
• Despite a Spanish housing bubble bigger than the recent one in the US, property prices in Spain have fallen from their peak by less than in the US.

On top of all this, the IMF (2012a, b) has estimated that Eurozone banks are likely to face pressures to deleverage more than $2 trillion of bank assets by the end of 2013. The fund has also warned that such deleveraging would slow EU economic activity and reduce the health of its banks.

In the face of such obvious banking fragility in the EU, the 15 May ECOFIN decision on bank capital seems divorced from realities.

With potentially large future EU bank losses on the horizon, constraining the ability of regulators in some EU countries to set minimum bank capital standards in excess of the Basel III minimums is imprudent. Doing so would prevent banks in some EU countries from having enough “self-insurance” to handle potential losses. Consequently, the burden of financing those losses would again fall unfairly on taxpayers and lead to greater dependence on the ECB for liquidity.

Cross-country differences in the size of too-big-to-fail banks call for cross-country differences in minimum capital standards

The 15 May decision also does not adequately address differences among EU countries in the extent of the too-big-to-fail problem and the implications for minimum bank capital ratios. The combined assets of the five largest banks relative to GDP are three times as high in the UK and the Netherlands (at about 450% of GDP) as in Germany and Italy (Goldstein and Veron, 2011).

The greater the size of too-big-to-fail banks in an individual country, the more pressing the need to provide adequate self-insurance against losses in those institutions. Such self-insurance must come from higher bank capital. It is thus no accident that two countries where the combined assets of the few largest banks are particularly large relative to home-country GDP – Switzerland and the UK – have already moved to enact national minimum bank capital standards tougher than those in Basel III (Goldstein, 2011).

The May 15 agreement constrains the ability of EU countries to set such rational self-insurance requirements for their banks. Those EU countries with large banks (relative to home-country GDP) will henceforth face two unpalatable choices. Either they will have to break-up their largest banks to minimise the government’s prospective liability – something that they have so far (unfortunately) refused to consider seriously – or they will have to accept (implicitly) the reality that if these very large banks do come under acute distress, the cost of saving or liquidating them will fall predominantly on taxpayers.

European leaders have pledged repeatedly to spare taxpayers from that burden. More generally, it makes no sense to constrain differences in minimum bank capital ratios across EU countries when there is no pan-EU deposit insurance and bank resolution regime in place and when there are sizeable differences in banking risk across these economies. Such differences reflect troubled legacy assets, sovereign debt burdens, cyclical positions, and longer-term structural factors (like the size of too-big-to-fail banks).

The minimum capital ratios in Basel III are way too low

Third, the minimum capital standards agreed under Basel III itself, while better than those in Basel II, are still way too low. Thus, individual countries – whether or not they are members of the EU – need the latitude to exceed those Basel III minimums in their own national legislation.

Such freedom supports the spirit of successive Basel bank capital agreements, which have always aimed to set minimum standards to prevent a race to the bottom and to avoid maximum standards that would discourage a race to the top. Costly banking crises occur when banks have too little capital – not when they have ample capital.

The literature suggests several approaches for estimating the minimum or optimal ratio of bank capital.

• One derives from the fact that banks typically hold bank capital in excess of the Basel minimums even at the bottom of the business cycle.

Banks arguably behave that way because the markets – nervous about the near-death experience of some banks in the previous crisis – pressure them to do so. The following question is then posed: if we want banks to remain solvent after suffering credit and trading losses in severe crises and still have enough capital to meet the market imposed minimum at the bottom of the cycle, how high would the minimum capital ratio have to be at the top of the cycle?

A recent study by Hanson, Stein, and Kashyap (2010) noted that U.S. banks lost roughly 7% of assets during the 2007-2010 period and that very large U.S. banks had a common tier one capital ratio (relative to risk-weighted assets) of about 8% in the first quarter of 2010 (near the bottom of the cycle). From that, they concluded that the minimum capital ratio needed to be about 15% at the top of the cycle – far above Basel III’s minimum 7% ratio (for common core tier 1 capital) or its 9.5% ratio for the globally most systemically-important banks. Applying this approach to other countries’ bank-loss experience and to banks’ capital holdings at different times generates estimates of minimum (common equity) capital ratios in the 12-25% range. Again, these levels are far higher than the Basel III minimums.

• A second approach is to employ a cost-benefit framework to the estimation of optimal bank capital ratios.

On the benefit side, higher capital reduces the probability of a systemic bank crisis that would depress economic growth and undermine government fiscal positions. On the cost side, higher capital is assumed to increase bank funding costs, lower loan volumes, and impede economic growth. A recent study done at the Bank of England (Miles, 2011) applied such a cost-benefit approach and concluded that the optimal bank capital ratio (as a percentage of risk-weighted assets) was about 20% – more than double the Basel III minimum for even the most systemically-important banks.

Also employing a cost-benefit approach, a group of twenty distinguished professors of finance (Admati et al, 2010a) concluded that the minimum unweighted leverage ratio for banks ought to be at least 15% – five times the minimum leverage ratio (3 percent) included in Basel III. The main reason why the cost-benefit approach leads to (optimal) minimum capital ratios higher than those in Basel III is that while the social benefits of higher bank capital are substantial, the social costs of higher bank capital turn out to be modest.

The yawning gap between the minimum standards in Basel III and the minimum standards derived from the best empirical evidence makes it counterproductive to prevent countries from imposing standards higher than those in Basel III.

The quality, not just quantity, of bank capital matters

Basel III was not just about increasing the quantity of bank capital. It was also about improving the quality of that capital so that it would be truly loss-absorbing.

In this regard, the Basel Committee on Banking Supervision (BCBS) was responding to one of the main lessons of the global economic and financial crisis: when banks are permitted to count financial instruments as regulatory capital that either are not fully loss-absorbing or are loss-absorbing only if and when the bank is being liquidated, de facto bank capital can be much less than regulatory capital and the government winds-up having to inject funds as common equity into the rescue.

To avoid repeating that mistake and to limit the future public-sector liability, Basel III emphasised the highest quality bank capital – namely, equity capital. It also restricted (to 15% of the common equity component) the combined weight of lower-quality financial instruments that had been previously allowed. These components included deferred tax assets, mortgage servicing rights, and significant investments in common shares of unconsolidated financial institutions (including insurance companies).

The parts of Basel III dealing with the quality of bank capital represent a compromise in which the US, Japan, and the EU each agreed to restrict a low-quality component of bank capital that was viewed as attractive by their own banks. For example, Japanese banks were reluctant to disqualify tax deferred assets, U.S. banks wanted to hold on to their mortgage servicing rights, and EU banks – particularly those with large insurance subsidiaries – wanted to retain their minority stakes in unconsolidated subsidiaries.

The 15 May EU agreement threatens to unravel the Basel III compromise on the quality of bank capital – largely to appease some German and some French banks, which do not want to go to the market to raise high-quality bank capital in order meet higher capital requirements under both Basel III and the EBA stress tests. Instead, these banks pressured their governments to convince other EU members that various low-quality capital components should satisfy such capital requirements. In that way, these EU banks can continue to pay dividends and dole out excessive compensation packages to employees.

If the 15 May concessions had not been forthcoming, these banks would likely be judged as under-capitalised.[3] The Schäuble View on the quality of bank capital should be seen for what it is: an effort to use smoke and mirrors to weaken the Basel III restrictions on the definition of high-quality bank capital. Some EU ministries of finance may also see short-term advantage in carrying the banks water on this issue. Recapitalizing the banks via government injections of capital, after all, would increase already high sovereign debt levels and would anger voters fed up with government bailouts of the financial sector.

The EU retreat on the quality of bank capital is likely to have two costly consequences.

• First, French and German banks will have less real, high-quality bank capital than advertised, putting French and German taxpayers on the hook for bank losses in excess of available, truly loss-absorbing capital.

Markets will see through this tactic, so there will be little if any advantage in funding costs.

• Second, giving French and German banks a pass from an important part of Basel III will almost surely encourage U.S. and Japanese banks, among others, to press for similar concessions from their national regulators, invoking other low-quality components of bank capital relevant to their balance sheets.

If successful, such efforts will weaken the effectiveness of the overall Basel III agreement and thwart one of its main objectives – forcing banks to become responsible for financing their own losses, without inflicting costs on innocent bystanders.

Unpersuasive arguments about the effect of higher capital requirements on economic growth and the single market

In campaigning against higher bank capital standards, the banking industry argues that a higher capital ratio will be a calamity in terms of increased bank funding costs, lower loan volumes, and slower economic growth. Unfortunately, most EU finance ministers seem to have bought into that fallacy. In addition, the Schäuble camp trotted out the equally weak argument that permitting EU countries to implement much higher minimum capital ratios than the Basel III minimums would jeopardise Europe’s Single Market.

Perhaps the best rebuttal of this contention has been made by Anat Admati and her colleagues at Stanford Business School and at the Max Planck Institute (Admati et al, 2010a, 2010b, 2011). A summary of their reasoning, which I strongly support, goes as follows.

• The cost of capital depends on the risk to which the capital is put.
• Relying more heavily on equity unambiguously reduces the volatility of the return on equity and lowers the risk premium on equity.
• The required return on equity must therefore decline with an increase in equity.
• The end result is that the bank’s overall cost of capital is likely to be little affected by increasing its capital ratio.

Nor does a higher capital requirement necessarily imply a reduction in loan growth unless banks are allowed to meet that requirement by shedding assets.

Unlike liquidity requirements over bank assets, capital requirements deal with the liability side of bank balance sheets and with funding choices. Banks do not hold the securities they issue; investors do. Capital is therefore not put in a strongbox. Many successful non-financial corporations fund themselves more heavily from equity than banks; yet these companies are not constrained by that funding choice in expanding their investments. Historically, the most severe credit crunches – like the 2007-2009 global crisis – occur when bank capital is very low, not when it is high. When leverage is low, such as the bursting of the internet bubble, the consequences for the macro-economy are much more benign that when leverage is high.

The empirical evidence on the effect of bank capital on bank funding costs and economic growth also supports the Admati View. For the US and UK economies it is possible to get time-series data on bank capital than go back to the 1840s. Over this long history, leverage ratios for bank capital varied widely. At times the ratio was more than four times higher than they are today. Yet statistical tests show no link between higher bank capital ratios and higher bank funding costs or weaker macroeconomic performance (Hanson, Kashyap, and Stein, 2010, and Miles, 2011). The cross-section evidence goes in the same direction. Small banks in the US routinely have much higher capital ratios than large banks, yet this difference has hardly led to their demise. The average capital ratio for non-financial companies in the US is 70 percent. Yet there no reason to believe that such a funding mix has hurt their performance.

The Schäuble View on the impact of bank capital requirements on bank lending also appears to run counter to that of the sitting Chairman of the European Banking Authority (EBA), Andrea Enria. In a recent (April 2012) speech, Enria (2012b, p. 10) said:

“On this, I want to be blunt. I do not believe that high levels of capital are a deterrent to new lending. On the contrary, banks with low capital levels—or perceived by the market as being so – are those that have had problems in increased lending. They either face major funding difficulties – which in turn do not allow them to grant loans – or focus primarily on preserving their meager capital. Banks with large capital positions, by contrast, are less sensitive to cyclical shocks and more likely to pursue lending growth strategies.”

The way in which higher capital requirements are implemented also matters. As argued in Goldstein (2012), when revealing the results of its stress tests and designing bank recapitalisation guidelines, the EBA should have included a firm policy on bank dividends and executive compensation. Any bank that did not meet the minimum capital ratio should have been directed to suspend dividend payments until it reached the target and was no longer in danger of falling below the target over the next year. The EBA should also have included an adverse macroeconomic scenario for the Eurozone to strengthen confidence in the stress test results. Last but not least, the target capital ratio should have been translated into a target for increases in bank capital alone. That step would have avoided giving banks an incentive to meet the target by decreasing the denominator (asset shedding) rather increasing the numerator (raising new capital).

The way forward

To sum up, denying EU countries the scope to raise minimum capital levels above the Basel III minimums, ostensibly to sustain lending and economic growth in the region, flies in the face of both economic theory and the evidence. Here too, the Schäuble View is merely another sop to the banks.

The argument that large differences in minimum bank capital ratios among EU countries would risk splintering the Single Market likewise has little foundation. As maintained by Veron (2012), the largest distortion to the EU market for financial services is that the framework for supervision and resolution of financial institutions remains predominantly national. For this reason, the financial health of banks is tied to the health of their home-country sovereigns. If EU finance ministers want to strengthen the single market for financial services, they should implement an EU-wide framework for deposit insurance and bank resolution, going if necessary beyond the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) (Roubini, 2012), along the lines of the Federal Deposit Insurance Corporation (FDIC) in the US. Tinkering with cross-country differences in minimum bank capital ratios will do little to advance the Single Market. And if the concern is that individual EU countries with high minimal bank capital ratios would use those minimums to shed assets outside their home market, this should be addressed by negotiating an EU-wide coordination agreement on cross-border bank lending, like the Vienna Initiative of 2009. A “convoy approach” to bank capital – in which EU countries seeking safer banking systems are barred from doing so out of fear of pressure on other EU countries with weaker regimes – will not promote the Single Market. As in the case of Japan’s banking crisis (Posen, 2000), such a convoy approach will delay addressing the problem of under-capitalised banks and weaken economic recovery in the euro zone.

The decision by European finance ministers on EU implementation of Basel III on 15 May is a setback for financial regulatory reform not only in Europe but globally. The priority ought to have been focused on increasing the quantity and quality of bank capital to deal with the under-capitalisation of EU banks and reducing the potential for an adverse feedback loop between bank debt and sovereign debt. Instead, EU finance ministers went in the opposite direction by constraining the ability of EU countries to do more than Basel III on the quantity of bank capital and by weakening Basel III on the quality of that capital. Their action will further undermine confidence in the solvency of EU banks and make resolution of the EU debt crisis more difficult. In addition, it will impede efforts to implement capital reforms of Basel III in the US and Japan, as banks in those countries try to engage in a regulatory race to the bottom.

Fortunately, EU Finance Ministers still must negotiate and agree on a final text of the EU bank capital rules with the European Parliament. The Parliament should take seriously its responsibilities in this area. It should demand significant changes to the 15 May ECOFIN draft agreement. Specifically, the Parliament should press ECOFIN: (i) to raise the (no-EU approval-required) threshold on national bank capital minimum above the Basel III minimum to at least 700 basis points (for total exposure); (ii) to reinstate the Basel III restrictions on what can be counted as equity capital; and (iii) to introduce the amendment that any EU bank failing an EBA stress test with regard either to the common Tier 1 capital ratio or to the leverage ratio should be prohibited from either paying dividends or employee bonuses until it reaches the bank capital target and is (in the EBA’s judgment ) not in danger of falling below the capital target over the next year. If these negotiations between the Parliament and EU Finance Ministers take a month or two, so be it: better to take the time to hammer out an agreement that promotes reform on bank capital than to rush into a compromise that undermines it.

References

Admati, Anat, and others, 2010a, “Healthy Banking System Is the Goal: Not Profitable Banks,” Financial Times, November 9.

Admati, Anat, 2010b, “Fallacies, Irrelevant Facts, and Myths in the Discussion Of Capital Regulation,” Working Paper, Stanford Graduate School of Business, August.

Admati, Anat, 2011, “Fallacies, Irrelevant Facts, and Myths in the Discussion of Of Capital Regulation: Why Bank Equity is Not Expensive,” Powerpoint Presentation, NBER Corporate Finance Panel, April 30.

Council of the EU, 2012, “Bank Capital Rules: General Approach Agreed Ahead of Talks with Parliament,” Brussels, 15 May.

Enria, Andrea, 2012a, “Supervisory Policies and Bank Deleveraging: A European Perspective,” 21st Annual Hyman Minsky Conference, “Debt, Defecits, and Financial Instability, New York City, April 11-12.

Enria, Andrea, 2012b, “Developing a Single Rulebook in Banking,” Conference on Financial Regulation, Central Bank of Ireland, April 27.

Goldstein, Morris, 2011, “Integrating Financial Regulatory Reform with Reform of The International Monetary System,” Working Paper No. 11-5, Peterson Institute for International Economics, February.

Goldstein, Morris, 2012, “Stop Coddling Europe’s Banks,” VoxEU, January 11.

Goldstein, Morris and Nicholas Veron, 2011, “Too Big To Fail: The Transatlantic Debate,” Working Paper No. 11-2, Peterson Institute for International Economics, January.

Hanson, Samuel, Anil Kashyap, and Jeremy Stein, 2010, “A Macroprudential Approach to Financial Regulation, Journal of Economic Perspectives

Helwig, Martin, 2010, “Capital Regulation After the Crisis: Business as Usual?” Max Planck Institute for Research on Public Goods, Bonn.

Independent Commission on Banking (Vickers Report), 2011, Final Report and Recommendations, London, September.

International Monetary Fund, 2011, Global Financial Stability Report, September.

International Monetary Fund, 2012a, Global Financial Stability Report, April.

International Monetary Fund, 2012b, World Economic Outlook, April.

Lagarde, Christine, 2011, “Global Risks Are Rising But There Is a Path to Recovery,” Jackson Hole Symposium, Federal Reserve Bank of Kansas City, August 27.

Miles, David, 2011, “What Is the Optimal Leverage for a Bank?” VoxEU, April 27.

Posen, Adam, 2000, “Introduction: Financial Similarities and Monetary Differences,” in A. Posen (editor), Japan’s Financial Crisis and Parallles to the U.S. Experience, Peterson Institute for International Economics.

Roubini, Nouriel, 2012, “What’s On Nouriel’s Mind: Greece Should Default and Exit the euro through an Orderly Divorce Process, RGE, May 14.

Veron, Nicolas, 2012, “The European Debate About Bank Capital Is Not Just About Europe,” VoxEU, May 4.

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