Crisis would test new bank capital rules

Last month saw the first step in one of the biggest transformations of banking regulation across the European Union since the 1974 collapse of Germany’s Herstatt Bank.

The Herstatt crisis triggered the creation of the Basel Committee on Banking Supervision and the first efforts to reach international agreements on the adequacy of bank capital.

In January, a new capital requirements directive (CRD), based on the Basel II banking accord drawn up by the Basel Committee, required more than 10,000 EU-based banks to abide by new rules, under a basic ‘standardised’ approach to calculating capital adequacy.

But around 40 of the EU’s biggest cross-border banking institutions, with assets of close to €20 trillion, have been given an extra year to comply. They will be using advanced rules, so-called internal ratings based, for credit risk and other sophisticated methods to calculate market and operational risk. The aim of the new rules is to encourage banks to align more closely their regulatory capital, what bank supervisors require, with their economic capital, what the banks themselves see as the cushion they need to protect themselves against risks and losses.

The new structure promises a revolution in the way banking supervision is carried out. But are there gaps in the new capital regime? Is it really going to contribute to the stability of the giant cross-border banks whose health is vital to both the functioning of the world financial system and the strength of Europe’s single currency? And will the CRD help to facilitate the cross-border banking business and consolidation which EU policymakers believe is essential to promoting faster EU economic growth? After all, the financial world has changed dramatically since the mid-1990s when discussion of a new capital adequacy regime began to intensify. More sophisticated financial derivatives markets have grown explosively in just the past five years and globalisation means that nation state based banking supervision is being overtaken by changes in the way market interact.

William White, chief economist of the Bank for International Settlements, the central bankers’ bank, has been arguing that a "new macro-prudential framework" is needed to back up capital adequacy requirements. It would encourage bank regulators and central bankers to promote more actively the health of the global financial system, partly by applying a wider variety of regulatory tools to curb financial market excesses. Other financial market experts say that the CRD/Basel II regime has paid too little attention to banking liquidity, which has only been addressed tangentially in the CRD/Basel II framework. "In the end banks fail because they run out of cash," says Alastair Clark, adviser to the governor of the Bank of England.

But arguably the biggest immediate challenge facing Brussels is how to get bank regulators in 27 member states to co-operate effectively. These officials speak 23 different languages and are applying different rules and regulations within different legal systems and cultures.

Level 3 of the so-called Lamfalussy process for financial market regulation is focused on promoting supervisory co-operation and convergence, and so battling the national protectionist impulses which are also blocking EU financial market integration. The Committee of European Bank Supervisors in London, set up as part of the Lamfalussy approach, is specifically tasked with pursuing these goals. But progress is slow and, with an interim review of the Lamfalussy process due shortly and a final report due at the end of the year, there are fears that a new approach may be needed.

Late last year Charlie McCreevy, the internal market commissioner, sought to increase the pressure for progress by issuing what was seen as a veiled threat of legislative action. "If supervisory convergence and co-operation are insufficient, the Commission will not hesitate to propose to strengthen the system," he said.

Gertrude Tumpel-Gugerell, executive board member of the European Central Bank has suggested a "stronger legal basis" may be needed to promote convergence. And at a financial market conference in Brussels on 23 January, Joaquín Almunia, the economic and monetary affairs commissioner, warned of "increased risks to financial stability" if prudential supervisors did not co-operate more closely.

According to one bank regulatory policymaker, it is this threat which will, in the next year, drive the efforts to promote increased supervisory co-operation.

There is growing, albeit publicly suppressed, concern about the EU’s ramshackle structures for supporting banks that are running into financial difficulties. There are, he suggests, no rules or processes in place even to deal with the early stages of a bank crisis by providing emergency liquidity.

A bank crisis management ‘war game’ in Frankfurt in April exposed just how vulnerable the EU financial system is. It prompted EU finance ministers to decide in September to set up a special sub-committee to study the issues. Incompatible deposit guarantee schemes across EU border are, for example, not only incompatible but also inadequate. Finance ministers, who have control of the taxpayers’ money that might be needed to bail out a bank in trouble, are, at last, becoming engaged.

Earlier this year former US treasury secretary Lawrence Summers warned that, although on the surface global financial markets are stable, there is growing concern over how durable this stability will prove to be. EU policymakers have long recognised that the new CRD needs flanking measures to support it if it is to promote EU and global financial stability. Now there is a new urgency in the efforts under way to develop them.

Last month saw the first step in one of the biggest transformations of banking regulation across the European Union since the 1974 collapse of Germany’s Herstatt Bank.