Following the Basel Committee’s publication of its new prudential framework for capital and liquidity (Basel III), the European Commission is now to propose amendments to the Capital Requirements Directive (“CRD 4”) to implement the changes in EU law. These proposals will have to be agreed by the Council and European Parliament.

The Economic and Monetary Affairs Committee of the European Parliament is also considering an Own Initiative Report. Whilst the report has no legislative status and does not form part of the co-decision procedure, it gives an indication of the concerns and stance of the Parliament, which presumably will be reflected later in the legislative process.

The main political thrust of the Parliament’s report is the perceived lack of involvement of the Parliament in the Basel process, which is stated to be a shortcoming reflected in the unfair competitive disadvantage the proposed framework will have on the European economy. The report points out that, whilst the US economy is largely financed via the capital markets, 80 per cent of investment in the EU is via bank credits; therefore, the proposal will have a bigger impact in Europe than in the United States. The conclusion is that the European Parliament should have an active role in future Basel negotiations. This proposal is unlikely to go far, but suggests that the Parliament may conclude that since it was not party to the Basel negotiations it is not bound by them and is at liberty to propose changes during the co-decision process outside the Basel framework. However, Parliament is likely broadly to support the aims of the Basel Committee. Another issue raised in the report is the need for all parties to adhere to a coherent implementat

ion calendar. This is a snipe at the United States and reflects the concern held by some MEPs as to whether the United States will implement the Basel proposals. The report also calls for EU implementation to take into account the state of the wider economy and in particular the financing of SMEs. In October 2010, the European Parliament announced that it had adopted its own-initiative resolution on implementation of Basel III into EU law.

The European Commission is now expected to issue proposals for amendments to the CRD under the co-decision legislative process by December 2010.

Comments on Basel III

On 12 September 2010, central bankers from 27 nations met at the Bank for International Settlements in Basel to agree new guidelines on the amount of capital (basically equity) that banks need to hold against the assets on their balance sheet.

The Capital Accord “Basel III” requires banks to hold more of the highest loss-absorbing forms of capital. Banks will have to hold core tier 1 capital (common equity and retained earnings) equivalent to a minimum of 4.5 per cent of risk-weighted assets (“RWAs”), compared with the current 2 per cent. Tier 1 capital requirements will increase to 6 per cent from 4 per cent.

The definition of common equity will also be based on tougher eligibility criteria. Previously, regulatory adjustments were made to Tier 1 and Tier 2 capital, but not to common equity. Common equity will now be calculated net of regulatory adjustments (such as deducting goodwill and intangibles and deferred tax assets arising from carried forward net losses).

The Basel Committee, however, has not yet finalised criteria for inclusion in Tier 1 capital. Treatment of contingent capital, for example, is still under discussion. Furthermore, while Basel III is tougher on the capital side of the minimum ratios, for the denominator it continues to use RWAs, which are a subjective measure of asset quality, rather than total assets.

Banks will be required to hold a further 2.5 per cent of RWAs as common equity to act as a “capital conservation buffer” to withstand periods of stress, which brings the total common equity requirement to 7 per cent. Banks will be allowed to use the buffer but, if they do so, they will face restrictions on earnings distribution. Basel III also endorses a second counter-cyclical buffer of up to 2.5 per cent of common equity or other fully loss-absorbing capital, but this will be implemented at national regulators’ discretion.

The minimum common equity, or core Tier 1, requirement falls below the level many countries were advocating including the UK and the United States. Other nations, such as Germany, argued that tougher regulations risked derailing the economic recovery and a compromise on lower levels and a more extended implementation period was agreed to overcome their objections.

The new minimum capital ratios will be phased in between 2013 and 1 January 2015, while the capital conservation buffer will be introduced on a sliding scale between 2016 and the start of 2019. The deductions from common equity will also be introduced gradually between 2014 and 2018, which should allow banks to benefit from most of the deferred tax assets relating to the financial crisis.

The Basel Committee is now working on additional requirements that will apply to systemically important banks, while two further aspects of the reforms are subject to a lengthy implementation period. First, a liquidity coverage ratio (“LCR”) will be introduced, requiring banks to hold sufficient high-quality liquid assets (cash and government bonds) to withstand a 30-day stress scenario. However, due to concerns over unintended consequences on financial markets and growth the LCR will not be effective until 2015, following an observation period. Meanwhile, a second liquidity measure, the minimum net stable funding ratio, which is intended to promote longer-term structural funding of banks, will not be introduced until the start of 2018. Second, a proposed non-risk-based minimum tier one leverage ratio of 3 per cent will now not be introduced until 2018, following a “parallel run” period from 2013 to 2017 and a subsequent review.

Making banks hold more, and higher quality, capital is clearly sensible. The crisis, however, revealed the full extent of the interconnected nature of the financial system and the regulatory response—appropriately—was to focus not just on capital but also liquidity and leverage. By introducing regulation over an extended period, the impact of this more comprehensive approach is watered down. With the response not fully in place until 2019, banks will have time to focus their powers of innovation on new ways of getting round the system. The suspicion remains that a regulatory package that is greeted with relief by the industry has not gone far enough.