Basel III - rewriting the rule book


5 December 2011


The Basel Committee on Banking Supervision has proposed a shake-up of banking legislation following the financial crisis, in a bid to shore up the banking sector and prevent future crises. Guido Ravoet, chief executive of the European Banking Federation writes that, as a result, the Capital Requirements Directive, which sets out the legal framework within which banks operate, is currently undergoing its third revision.


Currently, EU member states can adapt the banking rules enshrined in European legislation to national specificities, and even 'gold plate' EU requirements. This results in variations between prudential rule books in different European nations, which effectively distort competition, fail to deliver a level playing field across the EU, and create huge administrative difficulties for cross-border banks.

One of the main objectives of the revision of the Capital Requirements Directive (CRD IV) is to establish a 'single rule book', which would transpose the Basel rules uniformly throughout the EU. The number of options and discretions would be reduced, but the single rule book would nevertheless encompass differentiation according to national or product circumstances.

This raises the question of whether the new legislation should be presented in the form of a directive, where member states are expected to transpose it themselves into their national legal framework, or if the European Commission should produce a regulation, which would directly become law in each member state without the requirement of further implementing legislation.

"Basel III also proposes the introduction of a binding minimum leverage ratio requirement."

The Commission has opted for transposing the greater part of the Basel III rules into the CRD IV Regulation (for instance, those rules that are directly addressed to banks). Only provisions that are directly addressed to supervisors will be included in the CRD IV Directive - for example, counter-cyclical buffers and qualitative aspects, where supervisors may need to use their discretion.

In terms of scope, the financial institutions covered by the Capital Requirements Directive / Regulation will apply to all banks throughout the EU and also larger investment firms, while the Basel Committee standards were designed for internationally active banks. Not all Basel Committee members will extend the scope of the new rules to all their banks.

CRD IV distilled

What are the issues?

  1. The financial crisis revealed weaknesses in how banks were operating.
  2. The need for banks' corporate governance to improve.
  3. The need for more effective penalties to deter banks from infringing rules on capital requirements.

What will banks and investment firms have to do?

  1. Hold more capital of better quality so they can absorb losses.
  2. Build up 'capital buffers' as a further cushion against losses.
  3. Manage cashflow so they have reliable liquidity in the short and long term.
  4. Respect limits on assets they can take on in relation to the capital they hold (leverage), and hold more capital if they trade in complex financial products.
  5. Improve corporate governance.
  6. Abide by stricter rules or face increased penalties.

Who will benefit and how?

  1. Depositors: if there is less risk banks will fail, deposits will be better protected.
  2. Borrowers: banks will no longer need to cut back on loans to credit-worthy businesses, home-buyers and other borrowers in an economic downturn.
  3. Banks: they will be able to offer competitive products throughout the EU.
  4. Taxpayers: they will be less likely to have to bail-out failed banks.

When would the proposal come into effect?

  1. An EU regulation and an EU directive should be in place by the end of 2012.
  2. Many rules will be phased in gradually. The rules will be fully effective from 2019.

Definition of capital

Basel III reflects a global consensus in favour of enhancing quantity and quality of the capital requirements. The CRD IV Regulation largely reflects Basel III rules as to the requirements that capital must fulfil.

The CRD IV Directive deviates in some respects, in that it adapts the Basel rules to European specificities. For example, it doesn't automatically require banks to deduct significant investments in insurance companies, instead leaving it to the discretion of national regulators to decide whether banks are allowed to apply rules contained in the Financial Conglomerates Directive, which seeks to avoid double accounting. In other respects, it's more detailed and stringent in the requirements than Basel.

The Basel III liquidity rules primarily comprise two key ratios: the liquidity coverage ratio, for banks to meet their liquidity needs over a 30-day period of stress; and the net stable funding ratio, to reduce short-term asset and liability funding mismatches.

Both ratios are subject to observation periods until 1 January 2015 and 1 January 2018 respectively, when they take effect. The focus of CRD IV is on requiring banks to report on their holdings of qualifying liquid assets and on the maturity profiles of their liabilities, with a view to facilitating the analysis, to be conducted by regulatory authorities during the observation periods applicable to both ratios, which should assist a sensible calibration of the final requirements.

"It's essential Basel III is implemented globally, in order to preserve the competitiveness of Europe's banking sector."

From 1 January 2018, Basel III also proposes the introduction of a binding minimum leverage ratio requirement broadly composing of tier one capital expressed as a percentage of total exposures. Prior to that date, an observation period between 2013 and 2017 is proposed, during which time the effect and proper calibration of the ratio - provisionally set at 3% - will be assessed, with banks being required to report their leverage ratios from January 2015.

The CRD IV Regulation, unlike the Basel III rules, doesn't propose a minimum leverage ratio. It states explicitly, however, that a binding minimum leverage ratio will be introduced during 2018 with reporting of leverage ratios to commence in 2015. In the interim period, the CRD IV Directive requires national regulators to ensure that banks have policies in place to identify and manage excessive leverage, and that they address the risk of excessive leverage in a precautionary manner.

Level playing field

The issue of a global level playing field remains a significant challenge across the new regulations.

It's essential that Basel III is implemented globally, in order to preserve the competitiveness of Europe's banking sector, abroad as well as at home, where a level playing field between European banks must be an overriding priority.

However, it must be highlighted that the US is dragging its heels over the implementation of Basel. The US is still not working under the Basel II requirements and appears to be undecided on how to implement Basel 2.5, which has considerably increased the capital requirements for trading book and resecuritisation transactions. There is concern that the US's Dodd-Frank Act foresees that regulatory capital requirements should not be based on external ratings, which is a fundamental approach adopted in Basel II. Consequently, it's unlikely that the US will be able to implement Basel 2.5 within the given time frame, namely by the end of 2011.

Moreover, any time lag would be detrimental to the market activities of European banks because Basel 2.5 - introduced in the EU by way of CRD III in November 2010 - will result in substantial increases in capital requirements for these activities. Many of them will become less attractive starting year-end 2011, which is the objective of the regulation, but only for European banks and most probably not for their US competitors. The new requirements will have a particularly strong impact on the market-making capacities for credit and sovereign securities. European banks will have no choice but to reduce their inventories. It could then become a political issue if the trading of European bonds at the start of 2012 is concentrated in the hands of foreign banks due to the delayed implementation of Basel 2.5 abroad.

Finally, the impact the implementation of Basel III will have on the European economy needs to be taken into account, given that, in Europe, banks play a dominant role in lending to the private sector (75% of lending, compared with a mere 25% in the US).

Even if the impact of Basel III implementation will be manageable according to the Basel Committee and other competent authorities' studies, the comprehensive impact of all regulatory reform measures introduced or under consideration since the financial crisis erupted leaves banks and economic actors in an uncertain position as to the strength and length of the economic recovery.

Basel III implementation will have a huge effect on the European economic recovery.
Since January 2005, Guido Ravoet has been secretary general of the European Banking Federation.