Bloomberg News

Global Bank Capital Regime at Risk as Regulators Spar Over Rules

August 20, 2011

Aug. 20 (Bloomberg) -- Capital standards designed to fortify the global financial system are eroding as European officials, beset by a debt crisis, rewrite the regulations and U.S. rulemaking stalls.

The 27 member-states of the Basel Committee on Banking Supervision fought over the new regime, known as Basel III, for more than a year before agreeing in December to require banks to bolster capital and reduce reliance on borrowing. Now, as they put the standards into effect in their own countries, European Union lawmakers are revising definitions of capital, while the U.S. is struggling to reconcile the Basel mandates with financial reforms imposed by the Dodd-Frank Act.

“The game on the ground has changed in Europe and the U.S.,” said V. Gerard Comizio, a former Treasury Department lawyer who is now a senior partner at Paul Hastings Janofsky & Walker LLP in Washington. “The realists in Europe realized that their banks cannot raise the capital they’d need to comply. U.S. banks have reversed course and are more assertively fighting against it. The future of Basel III looks less certain now than it did when it was agreed to.”

The Basel committee revised its capital standards and outlined new rules on liquidity and leverage after the 2008 crisis exposed the vulnerability of the banking system. Credit markets froze following the collapse of Lehman Brothers Holdings Inc., sending the world economy into its first recession since World War II. Basel III was meant to create “a much stronger banking and financial system that is much more resilient to financial crises,” said Mario Draghi, who will take over as president of the European Central Bank in November.

Not Binding

Basel standards aren’t binding, so each country needs to write its own rules putting the agreed-upon principles into effect. The European Commission proposed regulations to parliament last month that would translate Basel III into law. A majority of EU governments also must endorse them. U.S. regulators led by the Federal Reserve have to come up with their own version, though they don’t need legislative approval.

The proposed EU rules, submitted by financial services commissioner Michel Barnier, omitted a ratio designed to improve banks’ cash positions, deferred decision on a rule to limit borrowing, revised capital definitions and extended some compliance dates. In the U.S., regulators are stymied because the 2010 Dodd-Frank Act bars the use in banking rules of credit ratings, which Basel III relies on to determine risk.

“Implementation is a big concern in Europe and the U.S.,” said Karel Lannoo, head of the Centre for European Policy Studies in Brussels. “The EU crisis isn’t over; the U.S. isn’t safely out of its mess. If we can’t get the rules that were supposed to protect the financial system from collapse, we won’t have changed anything to help us the next time around.”

Bigger Buffers

While the Greek debt crisis damped enthusiasm for tightening standards last year, the Basel committee managed to develop reforms to reduce risks in the financial system, according to Lannoo and other analysts. Increased capital requirements will create bigger buffers against losses. New liquidity rules will ensure banks have enough cash to deal with panicky customers withdrawing funds.

Renewed concern this year that Greece may be unable to pay its debts, and similar worries about larger EU members Italy and Spain, have darkened Basel’s prospects. The sputtering economic recovery in the U.S. and Europe has hurt, too.

$600 Billion Hole

The European Commission estimates that the region’s banks will have to raise about $600 billion to comply with the new capital rules. Banks say that will harm their ability to lend at a time when economies are flailing.

U.S. economic growth for the first quarter was revised down to 0.4 percent, while the second quarter’s initial figure was 1.3 percent. In Europe, gross domestic product fell from 0.8 percent in the first three months of the year to 0.2 percent in the second quarter.

Both the Bloomberg Europe 500 Banks and Financial Services Index and the KBW Bank Index of U.S. bank stocks have fallen about 30 percent this year. That wiped out more than $700 billion of market value on the two continents.

The European proposal alters the definition of capital that Basel III aimed to tighten when the committee agreed not to allow anything other than common shares to count toward the top- quality bank capital regulators examine.

Silent Participations

During the 2010 negotiations, Germany sought to maintain recognition of so-called silent participations -- hybrid securities that act like debt and equity at the same time -- which some banks rely on for more than half their capital. While Germany lost the battle to exempt silent participations last year, the EU’s implementation proposal was written to allow the securities to be included if they fulfill certain conditions, according to an EU official who asked not to be identified because he wasn’t authorized to speak.

At Landesbank Hessen-Thueringen, a state-owned lender based in Frankfurt known as Helaba, silent participations account for more than 50 percent of the bank’s 6 billion euros ($8.6 billion) of capital. Helaba withdrew from the Europe-wide stress tests in July after regulators refused to count some of those hybrid instruments as capital.

Italy fought during Basel talks last year to include deferred tax assets -- future deductions from tax liabilities resulting from current losses -- when calculating top-tier capital. Basel III restricted use of these assets to no more than 10 percent of a bank’s capital. The EU’s proposal would allow unrestricted use of deferred tax assets if they comply with certain requirements. Italy modified its tax laws in February to enable the assets to meet those conditions.

Counting tax assets would raise the capital ratio at Banca Monte dei Paschi di Siena SpA, the oldest bank in the world and Italy’s third-largest, by about 1 percentage point, according to a February Mediobanca SpA report on the benefits of the tax-law change to Italian banks.

Double Counting

Basel III also sought to put an end to the double counting of capital in insurance subsidiaries, which many European lenders do. The proposed EU rules don’t require banks to deduct investments in these subsidiaries from their capital, which will allow the double counting to continue, said analysts including Andrew Stimpson at KBW Inc. in London. That would benefit banks such as France’s Credit Agricole SA, whose insurance subsidiary accounts for 10 percent of income.

“Each adjustment may be justified in each country’s case, but when you put them all together, there will be differences between how the EU implements Basel III and how others do,” said Tobias Moerschen, a European bank analyst at Moody’s Investors Service in New York. “And if other countries feel compelled to go down the same road, you’ll end up with a less level playing field, and that is negative.”

Dimon, Ackermann

U.S. banks lobbying their regulators about the implementation of Basel rules can use the EU proposal as ammunition, Moerschen said. In March, Jamie Dimon, 55, chairman and chief executive officer of New York-based JPMorgan Chase & Co., said at a Chamber of Commerce event in Washington that it would disadvantage U.S. banks if European lenders were allowed to calculate capital ratios differently.

Josef Ackermann, the 63-year-old CEO of Frankfurt-based Deutsche Bank AG, fired a similar warning shot in a speech in New Delhi the same month: Separate regulatory approaches “would have severe consequences for financial markets and for the global economy,” he said.

Ackerman and other European bankers have complained that the U.S. never fully implemented Basel II, which was approved by the Basel committee in 2004. When community banks in the U.S. realized the regulations would give the largest international lenders the ability to lower their capital ratios, they lobbied lawmakers to prevent adoption of the rules. U.S. regulators, under pressure from Congress, delayed implementation.

Dodd-Frank Restrictions

Now the U.S. faces obstacles implementing Basel III because of conflicts with Dodd-Frank. The law’s ban on credit ratings was the result of criticism that Moody’s and other rating firms gave mortgage-related securities investment-grade ratings they didn’t deserve. That helped inflate a U.S. housing bubble as trillions of dollars of home loans were packaged into bonds and marketed to investors as safe.

While Basel III relies less on ratings than previous regimes, it still uses them to calculate risk. An international debate about what might replace external ratings has been as inconclusive as the one in the U.S.

Officials from the Fed and the Office of the Comptroller of the Currency told a congressional oversight panel last month that they have received numerous proposals and are still trying to come up with a formula that doesn’t rely on ratings firms.

“If the U.S. agencies are unable to implement the Basel committee changes that reference credit ratings, other jurisdictions may infer a lessening of the U.S. commitment to the Basel framework,” David Wilson, the OCC’s chief national bank examiner, told the panel.

141 Rules

Bank regulators at the Fed and other U.S. agencies have been busy implementing 141 rules mandated by Dodd-Frank, according to a tally by New York-based law firm Davis Polk & Wardwell LLP. As of July 22, regulators had completed 20, published proposals for an additional 24, missed 19 deadlines and had 78 to write, according to the Davis Polk report.

While Basel has taken a back seat to Dodd-Frank, U.S. regulators will be able to work around the ratings restrictions and propose rules to implement Basel III this year, according to two people involved in the discussions who asked not to be identified because they weren’t authorized to speak.

‘Big Holes’

U.S. regulators may be tempted to skip Basel altogether, said Karen Shaw Petrou, co-founder of Federal Financial Analytics Inc., an advisory firm in Washington.

“Dodd-Frank already takes care of the most important elements of the financial crisis, so why should we try to incorporate a set of rules into which big holes are already being carved?” Petrou said.

One hole may be opening in Basel III’s global leverage ratio. Unlike the capital ratio, which weights assets based on riskiness, the leverage standard compares capital with total assets without taking risk into account. The rule aims to limit how big a bank can get by capping how much it can borrow in relation to its common equity.

European banks had opposed a leverage ratio, arguing that different accounting regimes make the balance sheets of U.S. lenders smaller than those of their foreign counterparts and that restricting leverage would unfairly punish non-U.S. firms. While U.S. banks are subject to a leverage cap, Generally Accepted Accounting Principles allow them to keep more assets off their balance sheets and to net out derivatives more than International Financial Reporting Standards do.

Liquidity Standards

The Basel committee addressed the issue by devising a mechanism for adding total assets that puts aside different accounting standards. Still, the EU proposal doesn’t commit to implementing the ratio by 2018 as required by Basel III. Instead, it asks for a five-year period to review the rule’s effectiveness in curbing risk before deciding whether to make it binding.

The EU proposal also softens Basel III’s liquidity standards that would require banks to hold enough cash or easily sellable assets to meet short- and long-term liabilities. It omits the rule covering debt coming due in the next 12 months and modifies the one for 30-day obligations to allow counting covered bonds as liquid assets. Denmark, Sweden and Spain lobbied for the modification because their banks have sizeable holdings of those bonds, which are securities backed by the cash flow from a pool of mortgage loans.

‘Totally Faithful’

“The EU document is notable for its omissions of some key Basel concepts,” said Stimpson, the KBW analyst. “There are also tweaks in the capital definitions. I hope these don’t give Americans the excuse to say, ‘We’re not implementing Basel III.’”

Barnier, the financial services commissioner, and other EU officials have said the changes they incorporated into the implementation proposal are part of the natural process of translating global rules into local practice.

“We are totally faithful to Basel’s spirit, letter and level of ambition,” Barnier said in Brussels last month.

Different interpretations by national regulators emerged during previous incarnations of the accords, known as Basel I and II. Conflicts over Basel III could undermine the new regime if more countries follow Europe’s example and come up with their own versions of the rules, said Vishal Vedi, a London-based partner at Deloitte LLP’s financial-advisory practice.

“There’s concern that divergences between the EU and the U.S. on Basel III implementation will be bigger this time,” Vedi said. “There’s a line when the spirit of Basel III is tossed aside. I don’t think we’re there yet.”

--With assistance from Aaron Kirchfeld in Frankfurt, Jim Brunsden in Brussels, Gelu Sulugiuc in Copenhagen, Sonia Sirletti in Milan. Editors: Robert Friedman, Otis Bilodeau

To contact the reporter on this story: Yalman Onaran in New York at yonaran@bloomberg.net or on Twitter at @Yalman_BN.

To contact the editor responsible for this story: David Scheer in New York at dscheer@bloomberg.net.


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