This article was originally published in the Butterworths Journal of International Banking Law and Regulation.

The Basel III Accord has effect in the United Kingdom through the EU Capital Requirements Directive and Credit Requirements Regulation – the CRD IV package.

A hard Brexit would mean there is no reason for the CRD IV package to apply.

There are a number of possible areas where UK law makers or regulatory authorities could diverge from the current requirements under the CRD IV package.

Ultimately, the flexibility to diverge may be limited if the UK is to pass equivalence assessments for the purpose of various parts of the CRD IV package.

Introduction

Basel III and its impact on the prudential regulation of banks in the UK is old news.1 As with much else, however, the result in the Referendum on the UK's membership of the European Union has re-opened the story. The reason for this is that Basel III is implemented in the UK via the so-called "CRD IV package", referred to in this article as "CRD IV". CRD IV comprises the EU Capital Requirements Regulation 572/2013/EU (CRR) and Capital Requirements Directive 2013/36/EU (CRD IV Directive). In other words, Basel III entered the UK through the EU.

CRD IV does not simply ape Basel III but diverges in two general ways:

  • it provides further detail to the requirements set out in Basel III, to help create a harmonised banking regime across Europe, for example as to the exact requirements which need to be met for capital to be classified as Tier 1 or Tier 2 capital; and
  • it introduces requirements in addition to those in Basel III, which are designed to deal with perceived problems in the banking sector which Basel III does not address, for example and perhaps most controversially, with respect to remuneration.2

The future arrangements between the UK and the EU may take any of many shapes. On the one hand, the UK's admission to the European Economic Area or an individually tailored agreement which, inter alia, permits UK banks to passport into the EU Single Market could result in the continued application of CRD IV. On the other hand, were "out to mean out", then there would be no reason for CRD IV to apply. In this case, the UK would be in a position to make fresh rules when implementing Basel III.

Parting company: points of divergence

By no means a wish list, the following represent possible areas where UK law makers or regulatory authorities could diverge from the current requirements under the CRDIV whilst still complying with the requirements of Basel III:

Banker's variable remuneration

The CRD IV Directive imposes various requirements on the "variable elements of remuneration" including the condition that the "variable component ... not exceed 100% of the fixed component of the total remuneration for each individual".3 Although the Basel committee have been critical of compensation practices at financial institutions,4 a CRD IV type "bonus cap" does not exist in that Basel III framework, and, given the objection raised by the UK government when restrictions to "banker's bonuses" were introduced under CRD IV, the cap on remuneration seems to be a likely candidate for reconsideration.5

Definitions of Tier 1 and Tier 2 capital

Although largely similar, there are slight differences in the way quality of capital is measured in CRD IV in comparison with Basel III, for example CRD IV allows certain instruments to be treated as qualifying instruments, provided that they meet the required set of characteristics, despite not being ordinary share capital.6

Method of calculating amounts of capital

In general, CRD IV provides more detail in relation to the rules on deductions of capital, and so it may be that the UK could diverge on its interpretation of these rules from the EU.7

Levels of Tier 1 or Tier 2 capital

When CRD IV came into force, the UK objected to the levels of capital, seeking to impose a higher Tier 1 capital requirement than mandated under CRD IV.8 Outside CRD IV, UK authorities would have greater latitude to impose increased requirements to strengthen the reputation of the UK banking system, by showing that it has increased resilience compared to other countries.

Capital conservation buffers

Basel III requires banks to maintain a capital conservation buffer (consisting of common equity Tier 1) above a minimum requirement, and this is implemented by CRD IV.9 Failure to have this buffer affects the bank's ability to pay dividends, effect share buybacks, make discretionary payments on Tier 1 capital instruments and pay discretionary bonus payments to staff.

However, CRD IV adds detail to the Basel III requirements, which may be removed by the UK authorities, including:

  • explicitly stating that the restriction on discretionary staff bonus payments extends to discretionary pension benefits;
  • explicitly stating that discretionary staff payments where the obligation to pay was created at a time when the bank was in compliance with the capital conservation buffer requirement are not prohibited;
  • removing the option, allowed under Basel III in relation to additional Tier 1 capital, to include provision that, on any cancellation of a coupon, the payment by the issuer of a dividend on its ordinary shares would be prohibited for a certain period of time; and
  • adding further detail to the requirements of the conservation plan banks need to submit within five working days of becoming aware of any failure to meet the capital conservation buffer.10

Counter-cyclical buffers

The counter-cyclical buffer is an additional requirement to the capital conservation buffer, and is designed to create, at both the national and bank-specific level, capital buffers during times of excess credit growth which banks can then use to absorb losses in any ensuing economic downturn. CRD IV provides for the European Systemic Risk Board to provide additional guidance regarding the factors which EU member states may take into account when determining the national buffer, for example as regards the ratio of credit to gross domestic product and any specific risks to financial stability, and the UK authorities could no longer be subject to this guidance.11

Content requirements for countercyclical buffers

In particular, CRD IV requires the counter-cyclical buffer to consist of only common equity, whereas Basel III is more flexible in allowing other fully loss absorbing capital to be used. In the UK, these requirements could be loosened to enable banks to more easily meet their buffer requirements.12

Financial conglomerates

The UK authorities may no longer be subject to the EU consolidated supervision rules, which state that each competent authority is required to do everything within its power to reach a joint decision with the other competent authorities as regards European Union banking groups, on issues such as the required level of own funds to be maintained, and the rules relating to liquidity. Disputes on these issues under CRD may be referred to the European Banking Authority (EBA) whose decision is binding.13

Risk-weighted assessment (RWA)

CRD IV applies more stringent risk-weighted requirements than Basel III. For example, for lending fully secured by mortgages on residential property, the CRD imposes, in addition to lending fully secured by mortgages on residential property that is or will be occupied by the borrower being risk-weighted at 35%, a requirement that the part of the loan to which the 35% risk weight is assigned does not exceed 80% of the market value of the property in question or 80% of the mortgage lending value of the property in question in those member states that have laid down rigorous criteria for the assessment of the mortgage lending value in statutory or regulatory provisions.14 As such, if the UK were to leave the CRD regime, these criteria could be scaled back and so facilitate passing the RWA.

Internal hedges

Under CRD IV, internal hedges are defined and recognised in the calculation of capital requirements for position risk, provided that they are held with trading intent and the certain specified criteria are met.15 Basel III, however, does not deal with internal hedging, and so the UK has scope to change its position on the treatment of internal hedging if it leaves the CRD regime.16

Hot or cold or both?

As the list above indicates, there are many areas where the UK could make standards which diverge from those under CRD IV. There may be some pressure to do so if the UK would gain a competitive advantage as a result of doing so after leaving the EU. For example, in a letter of 30 June 2016 to Treasury Select Committee chairman Andrew Tyrie, the chief executives of seven challenger banks called for HM Government and the Bank of England to use their greater discretion on banking regulation, when CRD IV no longer applies, to adopt a "more proportionate approach" to banking regulation for smaller banks, in particular as regards capital requirements.17 The question is whether gaining a competitive advantage necessarily means imposing more or fewer requirements than those under CRD IV, while remaining true to Basel III and using Basel III as the catalyst for such change (noting the desire, of course, for the UK to adhere to international banking standards).

Basel III compliance is useful when applying to set up a branch within the borders of other foreign countries, such as the US.18 Basel III, could therefore, provide a "passport" of sorts to different countries. CRD IV does constitute a full-scale implementation of Basel III, but rather specific elements of Basel III are not implemented in the CRD IV.19 The prospect of a "passport" as part of an individually negotiated trade deal with non-EU countries is an interesting one and Basel III and other sets of international standards would set likely minimum standards for this.

An example of one area of stricter standards in Basel III than CRD IV is bancassurance, which refers to the, predominantly French, practice of amalgamating both banking and insurance practices into a single financial conglomerate. This practice caused concern amongst some of countries during the negotiation of Basel III, such as the US and UK, who were particularly concerned with avoiding Tier 1 capital protecting bank depositors being used to simultaneously protect insurance policyholders.20 Basel III aims to prevent this practice by requiring banks to deduct, from what otherwise would have been qualifying Tier 1 capital, the capital serving as "reserves" for the purpose of meeting the mandates of insurance regulation, however (despite objection from the UK at the time) this requirement was not implemented as part of CRD IV.21 Freed from CRD IV, the UK would have greater flexibility to implement those areas of Basel III which CRD IV does not, with a view to improving financial stability.

However, the flexibility which the UK may ultimately have to diverge from CRD IV, even if it ends up outside the Single Market, may be limited -- for example, the requirements for any "third country", which the UK would become after leaving the EU, to pass equivalence assessments for the purpose of various parts of CRD IV.22 If the UK wishes to pass this assessment, this may curtail its ability to deviate from CRD IV, in order for UK banks to maintain favourable relationships with EU banks. More generally, the concept of "more access to the EU, more compliance with EU standards" and the desire to avoid too many raised EU eyebrows about competitive advantages through lax UK regulation may mean that leaving the EU actually results in very little change. These issues remain political and uncertain, but the BASEL III/ CRD IV relationship, the UK's views on the inadequacy of CRD IV in implementing BASEL III, and the wider global regulatory landscape highlight the possibility that BREXIT may not necessarily result in less regulation.