“THE IMPLEMENTATION OF ‘BASEL III’ INTO THE

LAW OF THE EUROPEAN UNION”

STUDENT AUTHOR

Anastasios Repakis

DISSERTATION SUPERVISOR

Dr. Federico Ferretti

This dissertation is submitted for the degree of LLB of Brunel University - 2013. This

dissertation is entirely my own work and all material from other sources, published or

unpublished, has been duly acknowledged and cited.

___________________________ ___________________

Student Date

Acknowledgements:

I would like to take this opportunity to thank the staff at Brunel University for their

advice and support, in particular my dissertation supervisor for his invaluable advice,

encouragement and guidance throughout my dissertation project. I would like to thank

my family for supporting me in the pursuit of my ambitions and the special people in

my life who inspire me to always look further.

Abstract:

The reasons behind the ongoing financial and economic crisis the world today

experiences have triggered a large scale regulatory reform, both on international and

European level. This dissertation will attempt to survey and assess the recent changes

which are promoted in the Law of the European Union in order to supplement the

deficiencies of the pre-existing regulation of the banking system. The main focus will

be on the implementation of the recent recommendations made by the Basel Committee

on Banking Supervision, widely known as ‘Basel III’, as an international response to the

consequences of deregulation which led to today’s financial crisis. Finally, it will also

consider the dissenting arguments on banking regulation, in general, but also on the

criticism that has been particularly laid on ‘Basel III’.

Information will be obtained through the research of Committee reports, the European

Union’s legislation proposals relating to the implementation of the Basel

recommendations, bibliography regarding banking regulation in general and, mostly,

other academic resources which are more updated in regards to the ongoing

developments surrounding the issue in hand, such as journal articles. Furthermore,

reference will be made to working papers of international organisations which analysed

the actual impact on the market.

Table of Contents

Acknowledgments

Abstract

1. Introduction 1

1.1 The significance of banks in modern economy 1

1.2 The consequences of an unhealthy banking system: Financial Crises 2

1.3 Regulation: a compelling necessity 3

1.4 The Basel Accords: a step towards international regulatory coherence 3

2. Historical Overview 5

2.1 The Basel Committee and its initial activity 5

2.2 The 1988 Basel Accord 9

2.3 ‘Basel II’ and the Capital Requirements Directive 11

3. ‘Basel III’ 18

3.1 The Crisis of 2009: a result of deregulation and its impact on European growth 18

3.2 Why the pre-crisis European legal framework failed 20

3.3 The ‘Basel III’ recommendations 23

3.4 Implementation into European law 28

3.4.1 ‘Capital Requirements Directive IV’ 29

3.4.2 ‘Capital Requirements Regulation’ 32

4. Criticism 36

4.1 Expectations and Assessment 36

4.2 How has the banking system responded to the news of tighter regulation so far? 38

4.3 Can regulation backfire? 39

5. Conclusive Commends 42

Table of Statutes

Bibliography

1

1. Introduction

1.1 The Significance of Banks in Modern Economy:

Despite the fact that the notion of banking is ancient, the first institution which in some

way resembled what we refer to as a ‘bank’ today was established in Venice

approximately seven centuries ago. It was a public corporation designated with the duty

to manage the repayment of a loan the Venetian government required in order to finance

its war efforts.1

Since then, banks have acquired an indispensable role in modern economy. One of the

most important functions that banks perform is that they provide with an efficient

channel through which savings are used to finance undertakings which lubricate the

wheels of economy and promote growth. In addition, by supervising the progress of the

activity they finance, banks act as delegated monitors and promote healthy investments.

Another aspect of banking which has proven very useful for the economy is the

diversification of risk. Through their interconnected nature banks are able to export

assets with concentrated risk and minimise danger.2

1 Richard Hildreth, The History of Banks: To Which Is Added, a Demonstration of the Advantages and Necessity of Free Competition In the Business of Banking (Batoche Books 2001) 5 http://www.efm.bris.ac.uk/het/hildreth/bank.pdf accessed on 13 February 2013 2 Franklin Allen and Elena Carletti, ‘The Roles of Banks in Financial Systems’ (21 March 2008) 1,20 http://finance.wharton.upenn.edu/~allenf/download/Vita/Allen-Carletti-Oxford-Handbook-210308.pdf accessed on 22 February 2013

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1.2 Banks and Financial Crises:

The most basic affair of banking is the ability of investing the pooling capital from

customer deposits. Banks invest funds accumulated from savings and short-term

investments and invest them in long term assets. This activity allows banks to raise

more capital and impute interest to their customers in exchange for their deposits or

reinvest, therefore perpetuating the cycle of growth in economy. This process, however,

exposes banks to the possibility of depositors requiring their assets early, which leads to

what is referred to as a ‘run’. In such event banks are exposed and cannot fulfil their

obligations towards their customers. The situation outlined above is a superficial

description of a banking crisis and can be caused either by an event which shook the

confidence of customers towards the bank or due to misappropriation of the capital

which resulted to unsustainable losses.3

Despite the positive impact the globalised nature of today’s financial system has on the

apportionment of risk, it also allows a degree of interconnectedness which magnifies the

shock of a failure by spreading the contagion. This way, depending on the size of the

defaulting institution and its systemic significance, a banking crisis may rapidly evolve

to a financial crisis with the consequences everyone today experiences.

3 ibid 7

3

1.3 Regulation: a Compelling Necessity:

The need for regulation is commensurate with the significance of the banking sector in a

healthy economy. It is the vital significance of banking processes in today’s financial

system and economic structure which differentiates financial institutions from other

corporations and necessitates their protection through regulation. The term ‘regulation’

refers to a set of rules which governs the behaviour of institutions, enables designated

authorities to monitor the proper application of those rules and provides for the general

supervision of banks’ behaviour. Most commonly, regulation imposes specific standards

that need to be met and seeks to guarantee the existence of parameters which ensure the

viability of the institution, like capital reserves, liquidity and internal processes of risk

assessment. The task, however, is not an easy one and regulators face various

challenges. The increasing complexity in the nature of banking business, the speed of

transactions - which renders their effective supervision almost impossible - and the

implications of globalisation pose a serious challenge even to the most determined and

adequately informed regulatory body.4

1.4 The Basel Accords: a step towards international regulatory coherence:

The body which is committed to carry out the gigantic task of banking regulation on an

international level is the Basel Committee on Banking Supervision. The work of the

Basel Committee comprises of the adoption of certain standards which promote

4 Charles Goodhart, Philipp Hartmann, David Llewellyn, Liliana Rojas-Suarez and Steven Weisbrod, Financial Regulation: Why, how, where and now? (Routledge 1998) Introduction

4

sufficient capitalisation of financial institutions and effective supervision of the

financial sector. The recommended framework which incorporates the above standards

is known as ‘The Basel Accords’ and constitutes the matrix against which the most

significant economies of the world shape their banking regulations.5

At first, the following chapters will describe the historical evolution of the Basel

Committee, its initial recommendations and their first implementations into national

laws. Subsequently, attention will shift to the Committee’s most recent framework

which came as an answer to the financial crisis - widely known as ‘Basel III’ - and its

implementation into the law of the European Union. Lastly, the closing chapters will

consider the criticism to which the latest framework has been subjected and outline the

system’s initial responses to the new requirements.

5 Joe Larson, ‘The Basel Capital Accords’ (April 2011) 8-9 http://ebook.law.uiowa.edu/ebook/sites/default/files/Basel%20Accords%20FAQ.pdf accessed on 10 February 2013

5

2. A Historical Overview

2.1 The Basel Committee and its Initial Activity

According to its Charter, the Basel Committee on Banking Supervision “is the primary

global standard-setter for the prudential regulation of banks and provides a forum for

cooperation on banking supervisory matters. Its mandate is to strengthen the regulation,

supervision and practices of banks worldwide with the purpose of enhancing financial

stability.”6 The Committee is consisted of the Governors of the central banks of the G-

10 countries who represent the world’s most influential financial centres.7 The above

purpose is pursued through the exchange of information, within not only its members

but also international bodies and organizations, relating to the functioning of the

banking sector and financial markets in different jurisdictions which would allow the

Committee to identify risks of systemic exposure and regulatory gaps. Furthermore, the

Committee is supervising the consistent implementation of its proposals so that the

same standards are raised in different jurisdictions. 8

Despite its strong influence in laying down international guidelines on banking

supervision, it is important to clarify that the Committee does not possess any formal

supranational authority, neither its recommendations have any binding legal effect on its

members. Through its procedures, general standards and guidelines are created which

6 Bank for International Settlements, ‘The Charter of the Basel Committee on Banking Supervision’ (January 2013) 1 (‘The Basel Committee Charter’) 7 According to the Bank of International Settlements website, the countries represented in the Committee are Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. http://www.bis.org/bcbs/about.htm accessed on 11 February 2013 8‘The Basel Committee Charter’ (n 6) 1

6

point out to the right direction and promote regulatory coherence, although without

being followed by a mandate of compulsory implementation.9

The name of the Committee derives from the Swiss city of Basel, which is the base of

the Bank for International Settlements. The Bank of International Settlements hosts the

meetings of the Committee and provides with its permanent Secretariat.10 The

Committee meets four times a year, unless additional meetings are deemed necessary by

the Chairman, and it is the ultimate decision-making body, burdened with the

responsibility of ensuring that its mandate is achieved. The oversight of the Committee

lies with the Group of Governors and Heads of Supervision, also known as ‘GHOS’,

where the Committee will report, turn for direction and seek endorsement when a

decision is being made. The Chairman presides over Committee meetings and its

members are represented by appointed officials with the authority to commit the

institutions they act for. The Committee allocates and monitors its work by establishing

groups, work groups and task forces which are consisted of senior staff and technical

experts representing members of the Committee. The Chairman, besides chairing and

convening the Committee meetings, also monitors the progress of its activities, reports

to the GHOS and acts as the Committee’s representative. In addition, the Committee is

supported by a Secretariat, provided by the Bank of International Settlements. The

Secretariat is consisted of professional staff originating from the Committee’s members

and it is headed by a Secretary General. The Secretary General is appointed by the

Chairman and carries the duty of the Secretariat’s management.11

9 Basel Committee on Banking Supervision, ‘History of the Basel Committee and its Membership’ (Bank for International Settlements, August 2009) 1 10 Peter E Ellinger, Eva Lomnicka and Christopher V M Hare, Ellinger’s Banking Law (5th edn, OUP 2011) 77 11 ‘The Basel Committee Charter’ (n 6) 3 - 5

7

The establishment of the Basel Committee came in response to the collapse of

Bankhaus Herstatt, a banking institution of West Germany. It was concluded that the

failure of Herstatt was a direct result of lax banking supervision and lack of cooperation

between supervisory authorities. The Committee was established in December 1974 and

its first meeting took place in February 1975. Its initial concern was the adoption of a

number of principles that would allow the coherent supervision of banking institutions

with international activities. The Committee’s first recommendations were set out in the

Concordat of September 1975.12 The Concordat stressed the need of cooperation

between national authorities in order to ensure that no foreign banking establishment

escapes effective supervision. Furthermore, it laid down guidelines under which

supervisory responsibilities are divided between jurisdictions in relation to institutions’

liquidity, solvency and foreign exchange positions. Finally, in order to improve

cooperation amongst national authorities, the Concordat recommended the direct

exchange of information, the direct inspections of international establishments from the

authorities of the country where the parent institution is based and the indirect

inspections of international establishments with the local authority acting as an agent of

the parent authority.13

Despite it being a positive step towards a consistent international supervision of banking

activities, the 1975 Concordat failed to prevent the collapse of Banco Ambrosiano in

1983. This failure led to the review of the 1975 effort and to the Revised Concordat,

which was concluded in May 1983. The 1983 report incorporated the technique of

12 George Alexander Walker, International Banking Regulation: Law, Policy and Practice (Kluwer Law International 2001) 85 13 Committee on Banking Regulation and Supervisory Practices, ‘Report to the Governors on the Supervision of Banks’ Foreign Establishments’ (Bank for International Settlements, 25 September 1975) (1975 Concordat) http://www.bis.org/publ/bcbs00a.pdf accessed on 15 February 2013

8

consolidation which was first recommended in March 1979 and allowed parent

authorities to examine an institution’s business by including in the same balance sheet

activities of its foreign establishments.14 In addition to consolidation, the Committee

suggested that parent authorities should discourage institutions from extending their

activities to jurisdictions where supervision is inadequate and - vice versa – that host

authorities should act in the same manner and forbid inadequately supervised

institutions from expanding their business in their jurisdiction.15 A final addition to the

Concordat came in April 1990, when the Committee issued a report underlying the

importance of information flows between parent and host supervisory authorities.

Therefore, in order to increase supervisory collaboration, the Committee recommended

that a consultation between the parent and the host authority should be part of the

authorisation process. Furthermore, it suggested that a reporting routine should be

established between the foreign establishment and the parent bank so that the parent

authority has continuous access to consolidated information. Finally, the 1990 report

recommends that the parent authority should make available to the host authority all the

information that would make the supervision of the foreign establishment more

effective - “on the basis of mutual trust”.16

14 Walker (n 12) 85 15 Basel Committee on Banking Supervision, ‘Principles for the Supervision of Banks’ Foreign Establishments’ (Bank for International Settlements, May 1983) (Revised Concordat) http://www.bis.org/publ/bcbsc312.pdf accessed on 15 February 2013 16 Basel Committee on Banking Supervision, ‘Information Flows Between Banking Supervisory Authorities’ (Bank for International Settlements, April 1990)

9

2.2 The 1988 Basel Accord

Besides supervision, the Committee was also concerned by the continuously

deteriorating standards of capital adequacy. In order to control the growing risk

exposure and increase the stability of the banking sector on an international level, the

Committee considered the adoption of a regulatory framework which would require

risk-weighted assets to be balanced with a minimum ratio of capital. This led to the first

capital accord – known as the 1988 Capital Accord.17 The 1988 Accord was the result of

the widespread belief among the Committee members that regulatory convergence

would promote consistency, not only necessary for the soundness and stability of the

international banking system but also for the preservation of healthy competition

between international banking institutions.18

The Accord introduced a capital ratio which would measure the bank’s capital against

its exposure to risk-weighted assets. Under the new regime, an institution must have a

minimum capital ratio of 8% to be sufficiently capitalised. A key factor, however, in

assessing the capital adequacy of a bank is the quality of its capital. The Committee

decided that assessment of capital should be made in comparison to its ability to absorb

asset losses.19 Therefore, it established a two-tier division when defining capital. The

first tier consists of core capital (basic equity) which is common to every banking

system; it is a common variable for measuring capital adequacy, easily ascertainable

and has a crucial role in the institution’s profitability. The second tier capital is

considered less reliable and comprises of loan-loss and other reserves, subordinated

17 ‘History of the Basel Committee and its Membership’ (n 9) 2 18 Basel Committee on Banking Supervision, International Convergence of Capital Measurements and Capital Standards (BIS July 1988, updated to April 1998) 1 (The Basel Accord) 19 Joe Larson, ‘The Basel Capital Accords’ (April 2011) 8-9 http://ebook.law.uiowa.edu/ebook/sites/default/files/Basel%20Accords%20FAQ.pdf accessed on 10 February 2013

10

debt, deductions from capital and hybrid debt capital instruments. Underlining the

quality difference between the two tiers, the Committee suggested that the adopted

recommendations should be implemented in a way requiring at least 50% of the

institution’s capital to be consisted of core capital.20 The above distinction reflects the

Committee’s understanding that adequacy is a matter of quality – not quantity –and

capital requirements need to counterweight, not the number of the institution’s assets

but their exposure to risk.21

Similarly, the Committee adopted a multi-category qualitative division of risk-weighted

assets, based on the risk attached to them like credit-risk and the counterparty’s

probability of failure. Five classes of “weights” were created (0, 10, 20, 50 and 100%)

and each class added a different percentage of the value of the asset to the institution’s

overall exposure to risk. For example, assets like claims on central governments and

domestic public-sector entities fell under the first category and added 0% of their value

to the institution’s exposure because they were considered of low-risk. Riskier

activities, however, like loans secured by mortgage on residential property, add 50% of

the asset’s value and claims on the private sector add 100%.22

Finally, a significant contribution of the 1988 Accord was the inclusion of off-balance

sheet assets to the measurement of risk exposure by converting them to credit-risk

equivalents. Off-balance sheet activities are usually promises of credit, like an open line

of credit made available to a customers or a standby letter of credit which ensures

customers’ debts towards third parties will be covered by the institution in the event of

default. The Committee acknowledged the importance off-balance activities would have

20 The Basel Accord (n 13) 3 - 4 21 Larson (n 19) 10 22 The Basel Accord (n 18) 7-13

11

on the realistic measurement of risk and under the 1988 framework assets arising from

such activity are considered credit-risk equivalents.23

The recommended framework under the 1988 Accord was widely implemented and for

the first time a common framework on capital adequacy standards was created. Initially,

the new framework promoted market discipline and motivated undercapitalised

institutions to make the necessary adjustments and achieve the expected adequacy

ratios. In time, however, banks adapted to the new environment and learned how to

manoeuvre around the limitations the 1988 framework established. Banks developed

new techniques, like securitisation, which unveiled the broad nature of the 1988 capital

requirements and allowed banks to engage into capital arbitrage and artificially appear

adequately capitalised. Moreover, in their effort to achieve better ratios, banks found the

removal of risk-weighted assets from their balance sheets to be more efficient than

increasing their capital. The theory that a strict regime of capital requirements can lead

to credit crunches and affect real economy was partially affirmed by the consequences

lending reduction had to the US real estate sector after the first years of

implementation.24

2.3 ‘Basel II’ and the Capital Requirements Directive

The 1988 Accord was heavily criticised on the basis that it failed to provide a viable

solution to systemic risk exposure and the Committee decided that reform was on its

way. The proposed reform resulted to the release of a New Capital Framework in 2004

23 ibid 12 24 Patricia Jackson, ‘Capital Requirements and Bank Behaviour: the Impact of the Basle Accord’ (Bank for International Settlements 1999) Basle Committee on Banking Supervision Working Paper 1/1999, 1-5, 29 http://www.bis.org/publ/bcbs_wp1.pdf accessed 12 February 2013

12

after a five-year process of negotiations and consultations. The main objective of the

revised framework – known as ‘Basel II’ – was to create more risk-sensitive capital

requirements and not to change the level of capital banks need to hold as established in

the first accord. In addition, the revised framework sought to encourage the internal

assessment of risk and allocation of capital, in accordance to certain minimum

requirements which would guarantee the integrity of those internal procedures.25

In order to secure international convergence and provide with an integrated solution to

systemic risk exposure, the Committee adopted a common accord consisted of three

pillars: minimum capital requirements, which provide with an expanded and more

detailed framework than the first accord; supervisory review and assessment process,

which ensures coherent implementation of the adopted rules and better international

coordination amongst supervisory authorities; and disclosure requirements, which

promotes transparency and market discipline.26

The first pillar of ‘Basel II’ proposed two sophisticated approaches of risk assessment

that would give a realistic image of risk exposure and prevent banks from relying to

financial innovation in order to masquerade the risk inherent in their assets. The first

approach is the Standardized Approach and it has a similar way of assessing the weight

of risk attached on assets as the first accord. In addition to the five classes of ‘weights’

of the first framework - which carried 0, 10, 20, 50 and 100% of the asset’s value in the

calculation of the institution’s total risk exposure – the Standardized approach added

another two of 35 and 150%. A significant addition of the Standardized approach is that

25Rosa Maria Lastra, ‘Risk-based Capital Requirements and their Impact upon the Banking Industry: Basel II and CAD III’ (2004) JFRC 225 at 230; Larson (n 19) 14-15 26Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards: A Revised Framework (BIS, June 2004) 4-5 (Basel II); ‘History of the Basel Committee and its Membership’ (n 9) 3

13

the categorization of the asset would not be dependent on the generic identity of the

counterparty but on the credit rating the counterparty received by independent rating

agencies. The only exceptions would be non-rated assets which would fall automatically

to the ‘100%’ class and loans secured by mortgage on residential properties which fall

within the ‘35%’ class regardless of the counterparty’s rating.27

The second approach is the Internal Ratings-Based Approach and allowed - subject to

supervisory approval, certain minimum conditions and disclosure requirements - banks

to rely on internal procedures for the assessment of credit risk and the estimation of

‘adequate’ capital. Central to the application of the IRB approach is the notions of

institutions’ expected and unexpected losses. Losses characterized as ‘expected’ are

those which do not exceed the historical average of losses and allow banks to rely on

statistic data in order to calculate the necessary reserves that need to be made. However,

losses that exceed historical averages present a serious exposure to risk since they are

not foreseeable and banks may not be sufficiently capitalised to absorb them. In

predicting the severity of unexpected losses and calculating the resulting exposure, the

Internal Ratings-Based approaches base their estimation on certain components. The

first component is the ‘probability of default’ and it measures the counterparty’s ability

to meet its obligations and how probable the event of default may be. Another

component is ‘loss given default’ and provides with the net losses of the institution in

the event of the counterparty’s default. A third component is the ‘exposure at default’

and reflects on the additional losses a bank may sustain by other engagements with the

defaulting counterparty and – finally - the last component is ‘effective maturity’, which

estimates exposure based on the duration of the loan and the flow of repayments. The

27 Basel II (n 26) 15-22

14

above components are the key variables of the formula which banks will deploy when

following the IRB approach in calculating credit risk. Lastly, dependent on who

estimates the value of those components, IRB approach is divided in two sub-

categories: the Foundation IRB Approach and the Advanced IRB Approach. In

Foundation IRB the institution and supervising authorities estimate the value of the

above components jointly, whereas in Advanced IRB the institution is solely

responsible for that.28

It was, however, in the view of the Committee that capital adequacy requirements are

not in themselves sufficient to address the problem of systemic risk exposure.

Therefore, ‘Basel II’ included a second pillar which regulated the supervisory process of

capital adequacy upon principles that would encourage self-assessment but at the same

time would strengthen supervision. The Committee believed that banks should have an

internal process for assessing their overall capital adequacy in relation to their risk

profile and a strategy for maintaining their capital levels. In subsequence, this process

should be reviewed by supervisory authorities, as well as institutions’ ability to monitor

and ensure their compliance with regulatory capital ratios. In case the outcome of this

process was unsatisfactory, the second pillar enabled authorities to take appropriate

supervisory action where necessary. Even further, banks could be required to operate

above the minimum regulatory capital ratios and to hold capital in excess of the

minimum as ‘buffers’ against adverse market conditions when supervisory authorities

considered it necessary. Finally, under the second pillar, authorities could take pre-

emptive action if they become concerned that an institution fails to meet the adequacy

requirements. Such action could vary from simply intensifying supervision to requiring

28 Basel II (n 26) 48; Larson (n 19) 18-20

15

the bank to raise additional capital immediately and improve internal risk assessment

systems and controls.29

As a supplement of the first two pillars, the Committee incorporated into the ‘Basel II’

framework a third pillar which regulated market discipline through disclosure

requirements. The measure of disclosure sought to increase transparency by making

available to market participants information relating to the banks’ capital adequacy, risk

exposure and internal processes of risk assessment.30

Despite its detailed nature and the Committee’s influence on the financial world, the

‘Basel II’ three-pillar framework is considered as ‘soft law’ due to its non-binding

nature. The impact of ‘Basel II’ was significantly enhanced by its implementation into

the law of the European Union in 2005. The European officials incorporated the Basel

recommendations into two pieces of legislation, which together form what is being

referred as the ‘Capital Requirements Directive’. The first part of the CRD is Directive

2006/48/EC relating to the taking up and the pursuit of the business of credit

institutions. The second part is Directive 2006/49/EC on the capital adequacy of

investment firms and credit institutions. All institutions under the umbrella of the CRD

had to implement it by 1 January 2008. The purpose behind this legislative initiative

was the promotion of supervision and capital requirements convergence within the

Union by closing the gaps between the different national practices. Because of the

Union’s diverse nature, the Committees supervising the implementation of the CRD in

national law allowed a certain degree of flexibility to Member States but, as time

passed, consistent implementation was encouraged through the introduction of more

29 Basel II (n 21) 158 - 165 30 ibid 175

16

country-neutral approaches. Moreover, certain changes were introduced to the adopted

framework, which the officials in Brussels thought would better accommodate the needs

of the Union.31

In addition to the aforementioned difference on the binding effect of their provisions,

there are other areas where ‘Basel II’ and the CRD lack resemblance. A major

difference lies in the scope of their application since ‘Basel II’ was devised to regulate

the activity of large and internationally active banks, whereas the CRD applies to all

credit institutions. Additionally, the two regimes treat financial activities differently

when it comes to assessing the percentage of risk they add to the total exposure of the

institution. For example, when it comes to pillar one and capital requirements certain

financial products, like the highly-rated German bank debentures called ‘Pfandbriefe’ or

claims on High Volatility Commercial Real Estate, receive different risk evaluation

under the two frameworks. Likewise, noticeable differences have been detected in the

implementation of pillars two and three, like variations on the intensity of supervisory

reviews and the frequency of disclosure.32

In assessing the regulatory contribution of the Basel Committee through its

recommendations, one cannot fail to notice that each initiative was triggered from a

collapse of an institution or an event that exposed the financial system to substantial

risk. In addition, one also cannot fail to notice that each attempt did not prevent such

exposures from reoccurring. A significant conjuncture in the implementation processes

of ‘Basel II’ and the CRD was the outbreak of the global financial crisis of 2008,

because of which the weakness of the newly adopted framework were highlighted rather

31 Rym Ayadi, Basel II Implementation in the Midst of Turbulence (Centre for European Policy Studies 2008) 62-73; Ellinger’s Banking Law (n 10) 77; Lastra (n 25) 236; 32 Ayadi (n 31) 126-130

17

quickly and another regulatory initiative was triggered which resulted to – what is now

referred to as – ‘Basel III’. The following chapter will address the issues of the pre-2008

framework which allowed the crisis to become systemic and rendered the adoption of

further regulation a compelling necessity. Subsequently, it will outline the

recommendations adopted in ‘Basel III’, the degree of their implementation into EU law

and the results this implementation is expected to bring.

18

3. ‘Basel III’

3.1 The Crisis of 2009: a Result of Deregulation and its Impact on European

Growth

More than four years have passed from the collapse of Lehman Brothers33 and the

world’s economy is still struggling to recover from the consequences of the global

financial crisis of 2009. But before analysing how deregulation has resulted to the

exposure of global economy, some reference has to be made to the actual events that

destabilised the market.

The root of the problem can be found in the approach that the US government adopted

towards banking regulation in the ‘80s that “less is more”. This lenient approach

allowed banks to come up with complex financial innovations which allowed increased

profitability but at the same time carried equal amounts of risk. In addition, under this

regime of leniency, banks became more and more intertwined, rendering proper

supervision and regulation impossible without impeding growth. An important factor in

the adoption of this policy was the huge demand for liquidity. An example is the huge

rise in the demand for homeownership. The concept was that lax supervision and less

regulation would allow the banking sector to adopt techniques – like securitisation –

which would help them accommodate the increasing demand for homeownership in the

market. However, huge demand caused prices to soar and, since no regulation was in

place to prevent it, a bubble in the US real estate market was created. When the demand

was eventually satisfied and prices dropped, the value of most mortgaged properties was

33 September 2008

19

not enough to cover value of the loan for their purchase. As a result, the value of

mortgaged-backed securities plummeted and institutions which owned such assets – like

Lehman Brothers - were exposed.34

At the same time, the supervisory and regulatory regime that was put in place was

insufficient in preventing the consequences of Lehman’s failure from spreading to the

rest of the financial system. As a consequence of Lehman’s failure, liquidity evaporated

when the risk management tools put forward by ‘Basel II’ required banks to increase the

collateralisation of their down-graded securities. The lack of liquidity spread throughout

the banking system, stretching banks to their limits. The liquidity shortages choked the

market and caused the whole economy to shrink. Thus, the crisis evolved from

‘systemic’ to ‘economic’ and due to the globalised nature of today’s financial system

contagion spread throughout the world leaving none unaffected.35

In Europe the impact of the crisis was inevitable due to the close commercial connection

between the European Union and the United States. The same approach which

promoted transatlantic conformity in the nature of banking business also allowed the

crisis to spread instantly and led to the contraction of the Union’s financial indicators.

Both the European Union and the Eurozone experienced severe recession in 2009.

Moreover, unemployment rose and inflation decelerated. Additionally, and despite the

34 Éric Tymoigne, ‘Securitization, Deregulation, Economic Stability, and Financial Crisis, Part II: Deregulation, the Financial Crisis, and Policy Implications’ (August 2009) The Levy Economics Institute Working Paper 573.2/2009, 1-3 http://www.levyinstitute.org/pubs/wp_573_2.pdf accessed 16 February 2013 35 ‘Report of High-level Expert Group on Reforming the Structure of the EU Banking Sector’ (HLEG October 2012) 4-8 http://ec.europa.eu/internal_market/bank/docs/high-level_expert_group/liikanen-report/final_report_en.pdf accessed 15 October 2013 (Liikanen report)

20

contraction of Europe’s gross domestic product, its budget deficit almost doubled within

a year.36

Of particular interest is, however, the impact of the crisis on European Union’s

integration. Since the Treaty of Rome and the establishment of the European Economic

Community, progress in the project of integration has been slow but steady. Especially

when it came to economic integration, the commitment to pursue a common trade

policy led initially to the Single European Market and more recently to the adoption of

common currency between the Union’s core countries. Although progress in economic

integration is rather noticeable, the same thing cannot be said for the advancement of

integration in the political sphere, therefore creating certain asymmetries in policy

implementation between Member States. Those asymmetries became more apparent in

the turmoil of the crisis. The crisis nurtured euroscepticism and national policies

attempting to halt contagion fed the threat of introversion.37

3.2 Why the pre-Crisis Legal Framework Failed:

Even before the implementation of ‘Basel II’ and the occurrence of the financial crisis,

theorists identified the flaws of the recommended framework which failed to prevent the

economic decline the world faces today. One of the main issues of the ‘Basel II’

framework was the procyclical effect that capital requirements brought to the market.

36 Dennis J. Snower, ‘The Impact of the Global Financial Crisis on Europe and Europe's Responses’ (AEEF Conference, Kiel, July 2009) 2-3 http://www.bruegel.org/fileadmin/bruegel_files/Research_contributions/AEEF_contributions/Crisis_Developments_and_Long-Term_Global_Response/AEEF4PPDenisJ.Snower.pdf accessed on 16 February 2013 37 Marek Dabrowski, ‘The Global Financial Crisis: Lessons for European Integration’ (2009) CASE Working Paper 384/2009, 13-15 http://www.case-research.eu/upload/publikacja_plik/24767837_CNS&A384_April14_final.pdf accessed on 19 February 2013

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The term ‘procyclical’ refers to the intensification of financial fluctuations and

economic volatility. It was foreseen that if institutions had to hold more capital in order

to satisfy the requirements laid down by ‘Basel II’ access to liquidity would be limited,

therefore aggravating the consequences of a looming credit crunch. In addition to

procyclicality, target of criticism was the way ‘Basel II’ treated securitisation. Until the

crisis, the Committee treated asset securitisation as an efficient way to diversify risk by

redistributing it among different banking or non-banking institutions. However, the

same characteristics of securitisation which allow risk diversification also permitted

contagion to spread. Furthermore, the degree of discretion and flexibility given to banks

by the risk management tools adopted in ‘Basel II’ allowed them to use securitisation in

order to achieve regulatory arbitrage and hide the true risks inherent in their portfolios.

Thirdly, attention was drawn on the significant role rating agencies were called to play

under ‘Basel II’. Despite the heavy reliance based on them in the assessment of risk

weights, regulation and accountability of rating agencies did not correspond with their

significance. Without carrying any official status, opinions of rating agencies were

promoted from mere tools for differentiating credit quality to the highest authority in

measuring risk exposure. What is more, the fact that rating agencies receive

remuneration from the companies they assess may raise reasonable suspicion over their

impartiality. Finally, ‘Basel II’ was criticised over its consequences on competition in

financial services, since it applied only to banks leaving outside non-banking

institutions which may undertake some banking activities. In addition, the complexity of

its rules puts smaller banks in the tougher position and favours bigger institutions.

22

Lastly, the implementation of ‘Basel II’ has not progressed uniformly since different

jurisdictions – like USA and Europe - appraised it differently.38

Particularly in Europe, the procyclical character of ‘Basel II’ was introduced by the

Capital Requirements Directive. Furthermore, the diverse nature of the European Union

and degree of political integration achieved, prevented the regime’s full adoption and

justified some variations which would accommodate the Union’s distinguished

idiosyncrasy. This, however, resulted to regulatory gaps and supervisory inconsistencies

which undermined the effectiveness of the regime. In the aftermath of the crisis, it was

noticed that supervision focused more on the stability of certain components of EU’s

financial system (micro-prudential supervision), rather than addressing systemic risk en

masse (macro-prudential supervision). It was also noticed that the early risk warning

mechanisms put in place with CRD failed when at same time the transitional periods

and implementation processes of the Directive promoted uncertainty and undermined

any prospects of supervisory cooperation among national authorities.39

An important lesson from the financial crisis has been the impact of legal diversification

in a globalised system where international dependencies and externalities are constantly

on the rise. The systemic effects of incoherency in regulating financial processes of a

globalised economy have underlined the need for legal certainty through the

enhancement of supervisory cooperation and the safeguarding of competition. Gaps in

international supervision, along with financial innovations adopted by banks to achieve

38 Rosa Maria Lastra, ‘Risk-based Capital Requirements and their Impact upon the Banking Industry: Basel II and CAD III’ (2004) JFRC 225 at 234 - 235 39 Marianne Ojo, ‘Basel II and the Capital Requirements Directive: Responding to the 2008/09 Financial Crisis’ (September 2009) 3-5 http://ssrn.com/abstract=1475189 accessed on 20 February 2013

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regulatory arbitrage, exposed the ‘Basel II’ regime to a level which necessitated

amendments.40

3.3 The ‘Basel III’ Recommendations:

In order to put a halt to the momentum of the crisis and prevent the world from sinking

into depression, banks had to be recapitalised and access to liquidity restored.

Therefore, in considering the necessary amendments of the existing regulatory and

supervisory framework, the G20’s main focus was to ensure that governments would

never again have to bail out the sector. The Committee sought to remove any

assumption that banks may resort to taxpayers’ money to avoid failure and prevent

governments’ from facing again the dilemma of either bailing out a systemic institution

or exposing the whole economy to danger (what became known as “moral hazard”).41

According to Jaime Caruana – the General Manager of the Bank for International

Settlement - in achieving the above the new framework aim s to increase the level and

quality of capital, reduce systemic risk and allow sufficient time for a smooth transition

to the new regime by extending its implementation timeframe to 2019.42

In regards to the quality of the capital held by banks, ‘Basel III’ provided with a new

definition of regulatory capital, which is more restrictive and prevents inconsistencies

between jurisdictions. The composition of tier 1 capital becomes stricter and it is limited

only to equity stock and retained earnings. Simultaneously, the percentage of tier 1 40 Helmut Wagner, ‘Is Harmonization of Legal Rules an Appropriate Target?: Lessons from the Global Financial Crisis’ [2012] EJL & E 541 at 552-554 41 Richard Barfield, Sonja Du Plessis, Patrick Fell, ‘Basel III: Implications for Risk Management and Supervision’ [2011] COB 1 at 1-2 42 Jaime Caruana, ‘Basel III: Towards a Safer Financial System’ (3rd Santander International Banking Conference Madrid, 15 September 2010) 2

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capital has increased from 4 to 6% of the bank’s risk-weighted assets. In the same

direction, the Committee sought to increase the quantity of the capital held by banks. In

addition to the already existing capital ratio of 8%, the new regime introduces a capital

conservation buffer equal to at least 2.5% of the institutions risk-weighted assets, salted

away through the reduction of discretionary distributions of earnings.43

One of the lessons from the financial crisis was the implications of excessive leverage

on the banking system. Despite being adequately capitalised under ‘Basel II’, during the

crisis highly leveraged banks had to undertake deleveraging processes which negatively

affected the availability of capital and, subsequently, liquidity. Therefore, ‘Basel III’

introduces a leverage ratio of 3%, which requires banks to reserve capital equal to 3% of

its total assets. It is important to notice that the new leverage ratio is introduced

irrespective from the bank’s coverage against risk since its calculation is made in

comparison, not only to its risk-weighted portfolio but to its total assets. It is, therefore,

a “backstop” measure which adds up to the risk-based capital requirements by limiting

the ability of banks to maneuver around their capital adequacy obligations. The

Committee also believes that with its introduction the stability of the financial system

will be protected from the destabilising consequences a future crisis may have on an

excessively leveraged banking system.44

To further enhance financial stability in stressed periods, ‘Basel III’ sought to eradicate

the aforementioned element of procyclicality which characterised the previously

adopted framework. To that end, the Committee re-examined capital requirements

43 Basel Committee on Banking Supervision, Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems (BIS December 2010, rev June 2011) 12-13, 54-56 (‘Basel III’ on capital) 44 ibid 61

25

bearing in mind the relationship between banks and real economy and devised a

countercyclical buffer which would prevent the system from re-entering into a vicious

circle where economy is suffering from illiquidity which in return decapitalises the

banking sector and perpetuates the problem. The countercyclical buffer is implemented

as an extension of the capital conservation buffer mentioned above and it will range

between 0 and 2.5% of the institution’s risk-weighted assets. According to the new

framework, the actual percentage is left to be decided by national authorities and in

proportionality with the availability of credit in the economy. In simple words, the

concept of the countercyclical buffer introduces an additional requirement in periods of

low risk and credit growth which would guarantee liquidity in the event of a future

crisis by preventing banks from adopting drastic measures of capital conservation.45

However, the financial crisis taught regulators that capital requirements are not enough

in themselves to limit systemic risk exposure and highlighted the inability of the

previous framework to capture all material risks on and off the balance sheet. Thus, the

new regime refrained from just imposing higher capital requirements horizontally. On

the contrary, it recommends measures which promote the centralisation of derivative

transactions, create incentives for following more efficiently supervised processes (such

as moving OTC derivative contracts to central counterparties) and raises counterparty

credit risk management standards. Finally, in limiting systemic exposure ‘Basel III’

decreases the reliance of the previous framework to external rating agencies. Under the

new regulation, institutions have to perform their own assessments to externally rated

assets and adopt practices which prevent the procyclical implications of external ratings

45 ibid 57-60; Joe Larson, ‘The Basel Capital Accords’ (April 2011) 25-26 http://ebook.law.uiowa.edu/ebook/sites/default/files/Basel%20Accords%20FAQ.pdf accessed on 10 February 2013

26

oligopoly. Furthermore, the new regime strengthens the eligibility criteria for qualifying

as an external credit assessment institution.46

In addition to securing that the banking sector has access to adequate quantity and

substantial quality of capital, ‘Basel III’ recommended measures for promoting sound

liquidity risk management. An introduction by ‘Basel III’ which aspires to enhance the

shock-absorbing capacity of banks is the liquidity coverage ratio (LCR). Through this

new requirement the Committee wishes to ensure that in periods of financial and

economic stress, institutions will have access to adequate liquidity for 30 calendar days.

Banks must hold a number of unencumbered high quality liquid assets (HQLA) which

can be converted to cash in private markets quickly and without losses in order to

enable banks to survive a 30-day stress scenario. The new framework provides with

detailed characteristics of which assets would be accepted as ‘high quality’ and divides

them into two categories. Assets which fall within the first category can cover an

unlimited share of the total stock and they cannot be subjected to a haircut. Those

include coins and banknotes, central bank reserves and marketable securities which

carry no risk and satisfy very strict conditions. On the contrary, assets falling within the

second category are limited to 40% of the total stock after they have been subjected to a

15% haircut and may comprise of highly reliable corporate debt securities or marketed

securities which under ‘Basel II’ would carry only 20% of their value to the total

amount of risk-weighted assets. Lastly, it is in the discretion of national authorities to

include to the second category securities which can be subjected to bigger haircuts.

46 ‘Basel III’ on capital (n 43) 3-4

27

However, this discretionary addition cannot cover more than the 15% of the overall

stock.47

To supplement the short term effect the liquidity coverage ratio, the Committee adopted

another metric in order to promote the medium and long-term liquidity. The new tool is

called net stable funding ratio (NSFR) and requires institutions to ensure their

accessibility to stable funding sources, sufficient to cover the liquidity needs of the bank

for a year.48

A final addition of ‘Basel III’ is a number of monitoring tools which enable supervisory

authorities to better assess the sound liquidity of the banking sector. According to the

new framework, conclusion over liquidity will be drawn in relation to five different

parameters. Firstly, authorities will compare the contractual inflows and outflows of

liquidity within defined time periods and depending on their findings they will draw the

institution’s contractual maturity mismatch profile. This parameter enables supervisory

authorities to measure the institution’s reliance on maturity transformation under its

current contracts. A second parameter is the concentration of funding, under which

authorities have to identify the sources of wholesale funding which would cause

liquidity problems to the institution in the event of withdrawal. The utilization of this

parameter gives an image, although not detailed, of the institution’s behavioural

tendencies in relation to the way it pursuits funding. Thirdly, an aspect supervisors

should take into consideration is the number and details of the institution’s

unencumbered assets. This information can provide authorities with a view over the

47 Basel Committee on Banking Supervision, Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools (BIS January 2013) 6-7, 11-15 (‘Basel III’ on liquidity) 48 Basel Committee on Banking Supervision, Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring (BIS December 2010) 25

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bank’s potential to add more HQLAs to the LCR’s numerator. A fourth parameter

which under the new regime supervisory authorities have to take into consideration is

the calculation of the institution’s LCR by significant currencies. This parameter allows

banks and supervisors to track potential currency mismatch issues which could have

unforeseen implications in a period of stress. Finally, a last parameter which would

enable supervisory authorities to efficiently monitor the soundness of liquidity of the

banking sector is the process of market-related information. A closer look to the market

may reveal behaviours and reactions which indicate liquidity issues.49

3.4 Implementation into European Law:

The outbreak of the crisis in 2008 made evident that the revision of the ‘Basel II’

framework was on its way. The initial reaction from the Committee was to introduce

rules which limit regulatory arbitrage through securitisation and closely regulates

internal governance and staff compensation. Within the EU those first reactions were

incorporated with the introduction in 2009 of several pieces of legislation which came

to cover the gaps of the first CRD and became known as ‘CRD II’50 and ‘CRD III’51.

The revision process that took place in Basel and Brussels was parallel. Almost

simultaneously with the publication of the ‘Basel III’ consultation results, the European

49 ‘Basel III’ on liquidity (n 47) 40-47 50 Directive 2009/111 51 Commission Directive 2009/27; Commission Directive 2009/83 and Directive 2010/76

29

Commission published the consultation which resulted to the ongoing legislative

activity which implements ‘Basel III’ into EU law.52

The ‘Basel III’ framework is going to be implemented into EU law with the

introduction of a directive - known as ‘Capital Requirements Directive IV’53 – and a

regulation – known as ‘Capital Requirements Regulation’54, both of which are expected

to change the current legislation in its entirety. As mentioned above, the implementation

process is still ongoing and changes still take place, therefore this research will limit its

ambit to the progress made up to January 2013 which was the initial deadline for the

implementation of ‘Basel III’.

3.4.1 ‘Capital Requirements Directive IV’

Although the legislative documents had not been finalised in detail up to January 2013,

the broader changes the new directive will introduce have been made available to the

public. Furthering the amendments made with ‘CRD II’ and ‘CRD III’, the new

Directive replaces Directive 2006/48 which was one of the two pieces of legislation that

implemented ‘Basel II’.

52 Bart P.M. Joosen, ‘Further Changes to the Capital Requirements Directive: CRD IV – Major Overhaul of the Current European CRD legislation to Adopt the Basel III Accord: (Part 1)’ [2012] JIBLR 45 at 45-46 53 Commission, ‘Proposal for a Directive of the European Parliament and of the Council on the Access to the Activity of Credit Institutions and the Prudential Supervision of Credit Institutions and Investment Firms and Amending Directive 2002/87 of the European Parliament and of the Council on the Supplementary Supervision of Credit Institutions, Insurance Undertakings and Investment Firms in a Financial Conglomerate (Capital Requirements Directive IV)’ COM(2011) 453 final 54 Commission, ‘Proposal for a Regulation of the European Parliament and of the Council on Prudential Requirements for Credit Institutions and Investment Firms (Capital Requirements Regulation)’ COM(2011) 452 final

30

By comparing the new Directive to its predecessor, one quickly understands the depth

of the reform from significant amount of introductions which have been implemented.

In general, the new directive extends its scope to investment firms along with credit

institutions; strengthens prudential supervision by promoting cooperation between

supervisory authorities; creates a coherent sanctioning regime for institutions which fail

to comply with the new framework; introduces further changes to corporate governance

by promoting sustainable and responsible policies and implements the new capital

requirements recommended by ‘Basel III’.55

In regards to supervision, the new Directive requires Member States to designate

specific authorities which would monitor the proper application of the new framework

within their jurisdiction.56 In addition, it introduces the European Banking Authority

with a central role in monitoring the activities of the banking sector, therefore

promoting regulatory and supervisory convergence.57 Finally, in promoting supervisory

cooperation the new directive provides a more detailed outline of cooperation between

the supervisory authorities of Member States, not only regarding the functioning of

credit institutions and investment firms but financial stability in general.58 The new

Directive requires the establishment of an information channel between Member States

through which supervisory authorities will be able to exchange information regarding

capital adequacy and liquidity ratios of institutions which hold branches in more than

one Member State.59 Finally, the new Directive enhanced the ability of authorities to

conduct effective supervision by enabling them to impose sanctions to institutions

55 Joosen (n 52) 46-47; Graeme Baber, ‘Basel III implementation and the European Union: the proposed Capital Requirements Directive (CRD IV)’ [2012] Company Lawyer 341 at 342,348-349,353 56 COM(2011) 453 final, CRD IV Art 5(2) 57 Baber ‘CRD IV’ (n 55) 343 58 COM(2011) 453 final, CRD IV Art 52(1) 59 ibid Art 51(2)

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which fail to comply with the new regime. Sanctions may include the imposition of

specific disclosure requirements, restrictions in profit distribution – even withdrawal of

authorisation.60

Equally important is the contribution of the new directive towards the regulation of

corporate governance and effective risk management. The new regime promotes

internal risk assessment procedures in an attempt to limit overreliance to credit rating

agencies.61 To achieve this, institutions have to conduct periodical reviews of their risk

management processes and risk-weighted assets and adopt policies and procedures

which would identify any risk of excessive leverage. In addition, the new Directive

requires each significant institution to establish a risk committee which would have an

advisory role to the institutions strategy towards risk.62

In relation with capital requirements, the ‘CRD IV’ incorporates into EU law the capital

conservation and countercyclical buffers as recommended by ‘Basel III’. There is,

however, a differentiation in their implementation.63 The directive leaves authorities

with the discretion to relieve investment firms of low significance to financial stability

from the obligation to hold such reserves.64 Lastly, another possible derogation from

‘Basel III’ in relation to capital buffers is the adoption of a discretionary systemic risk

buffer to supplement the buffers included in ‘Basel III’.65

60 ibid Art 18, 99-102 61 Joosen (n 52) 46 62 COM(2011) 453 final CRD IV Art 75(3) 63 ibid Art 123, 124 64 Baber ‘CRD IV’ (n 55) 354 65 ibid

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3.4.2 ‘Capital Requirements Regulation’

The second piece of EU legislation implementing the ‘Basel III’ recommendations is

the Capital Requirements Regulation. In supplement to new Directive, the Regulation

implements the new framework regarding the definition of capital, conservation against

unforeseen counterparty credit risk, safeguarding of liquidity and monitoring of

excessive leverage.66

The CRR implements fully the ‘Basel III’ conditions under which assets may be

considered as ‘tier 1’ capital, in order to ensure that only the highest quality instruments

would be recognised as the highest quality form of regulatory capital. Such instruments

are usually limited to ordinary shares of the institution. Additionally, in order to

promote legal certainty, the new framework imposed to the European Banking

Authority the duty to publish a list of instruments which satisfy the aforementioned

criteria.67

Furthermore, the Regulation treated similarly the position of ‘Basel III’ over the

mitigation of unforeseen counterparty credit risk by introducing a capital charge. In

order to mitigate counterparty credit risk, the new regime requires institutions to

establish a management framework which would lay down policies and processes under

which such risks will be identified and measured.68 Moreover, the new Regulation also

includes detailed methods for calculating the value of such risk exposure.69

Another part of the ‘Basel III’ framework addressed by the CRR is liquidity. Part 6 of

the Regulation includes provisions dealing with liquidity coverage of institutions and

66 COM(2011) 452 final 11, 13-14 67 ibid ‘CRR’ Art 24, 25(2), 26 68 ibid ‘CRR’ Art 280 69 ibid ‘CRR’ Art 269 – 278 (Sections 3-6)

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the obligation of disclosure. In regards to liquidity coverage ratio, the CRR provides

that institutions must hold at all times a number of high quality liquid assets, the value

of which would suffice to cover the short-term liquidity needs of the institution in

stressed periods where access to liquidity is limited.70 The CRR includes provisions

which estimate the value of liquid assets and measure the volume of liquidity outflows

in order to calculate the liquidity coverage ratio.71 In addition, under both normal and

stressed circumstances, institutions expected to have taken positive action to ensure that

their long-term funding requirements are sufficiently met with a variety of stable

funding instruments, in correspondence with the ‘net stable funding ratio’ adopted by

‘Basel III’.72 Likewise, the Regulation requires institutions to report to supervisory

authorities the liquid assets they possess so authorities can draw a detailed picture of the

institution’s liquidity risk73 and describes which conditions have to be met for an asset

to be reported as a ‘liquid asset’74.

Finally, the CRR introduces to EU law the leverage ratio, as a regulatory tool which

would further enhance institutions’ ability to absorb shocks in demanding periods. The

Regulation – like ‘Basel III’, leaves its imposition to the discretion of national

supervisory authorities, but establishes reporting obligations in order to collect

necessary information which will support its future introduction as a binding measure.75

In practice, the leverage ratio is the division of the institution’s capital by its total

70 ibid ‘CRR’ Art 401 71 ibid ‘CRR’ Art 406, 408-412 72 Graeme Baber, ‘Basel III implementation and the European Union: the proposed Capital Requirements Regulation (CRR)’ [2012] Company Lawyer 386 at 396 73 COM(2011) 452 final Art 403 74 ibid ‘CRR’ Art 404 75 ibid 14 (Part 1, para 5.6)

34

exposure and the Regulation provides detailed instructions of measuring the capital and

exposure values.76

Before closing with the Capital Requirements Regulation, some remarks have to be

made in regards to the significance of the EU officials’ decision to employ a regulation

as the legislative instrument which will embody such extensive reforms. The

importance lies within the difference between a regulation and a directive. In contrast

with a directive, the fact that a regulation is not subjected to any implementation

procedures means that the new framework will be automatically applicable to 27

different jurisdictions. This creates an integrated regime – a ‘single rulebook’ - which

guarantees regulatory coherence throughout the Union. The efficiency of the regulatory

process allows authorities to respond swifter to market fluctuations and prevent

distortions. Furthermore, by eradicating differences in implementation, the new

regulation signifies important progress towards certainty and transparency within the

banking sector.77

As it was mentioned earlier, the implementation of ‘Basel III’ recommendations is still

in progress. Beyond any doubt, it is by far the most extensive regulatory activity ever

undertaken in relation to the banking sector, commensurate with the severity of the

crisis it is called to resolve. As a natural consequence the recommended reforms have

attracted a lot of attention and triggered endless debates over the possible results they

may bring. The following chapter will compare the expectations of the regulators with

the first reactions of the banking system to the news of reform and close with the

76 ibid ‘CRR’ Art 417 77 Joosen (n 52) 47

35

arguments of the dissenting voices which believe that overregulation may lead to

unanticipated results.

36

4. Criticism

4.1 Expectations and Assessment:

The reform is expected to create a safe and transparent financial system, which is able to

meet the needs of economy and society. In a period of recession, regulators expressed

their faith that the new framework will remobilise the economic variables which

promote sustainable growth and enable the financial system to steadily lubricate the

wheels of real economy. The measures adopted by Basel and the EU aspire to increase

not only the resilience of the banking sector, but also the financial system as a whole by

reinforcing the capacity of market infrastructures and non-bank financial institutions to

absorb shocks resulting from a potential bank failure.78

In specific, proposed and agreed reforms are expected to guard the credit and financial

institutions from systemic exposure to risks arising from the uncontrolled trading of

derivatives, the frivolous risk assessment of securities and overreliance to limited

sources of wholesale funding. In addition, the new regime is expected to prevent the

formation of bubbles in the values of capital assets, contain the endless circle of debt

which burdens real economy and abolish any regulatory parameters which encourage

procyclical behaviour within the system. In regards to the shock absorbing capacity of

market infrastructures and other financial institutions, the coherent nature in the

implementation of the new framework is anticipated to significantly reduce contagion

by promoting more responsible internal governance policies and provides to supervisory

78 ‘Report of High-level Expert Group on Reforming the Structure of the EU Banking Sector’ (HLEG October 2012) 67 http://ec.europa.eu/internal_market/bank/docs/high-level_expert_group/liikanen-report/final_report_en.pdf accessed 15 October 2013 (Liikanen report)

37

authorities the necessary tools for monitoring the systemic risk. Moreover, the adoption

of new capital and liquidity buffers is expected to restore confidence of depositors to the

banking sector and minimize the chances of bank-runs in the event of future failure.

Lastly, the ultimate intention is to reach a degree of stability and transparency where no

institution will be considered ‘too big to fail’ by reducing co-dependency and, therefore,

removing the fear of another bailout scenario.79

In evaluating the new regulatory and supervisory framework it is important to

acknowledge the contribution of the newly introduced shock-absorbent capital

requirements in enhancing the financial sector’s protection against risk exposure and

delimiting the chances of failure. Financial experts have recognised that the ‘Basel III’

initiative is a positive development in the struggle towards effective supervision capital

adequacy and containment of systemic risk and fully support its consistent

implementation.80

However, critics have noticed that some of the proposed reforms may not be enough to

provide with an absolute answer to regulatory weaknesses which failed to contain the

crisis. Although, ‘Basel III’ implements measures which address trading and derivatives

exposures, experts underline that the insistence of regulators to rely on requirements

based mainly on risk-weighted assets indicates that officials have not yet understood the

necessity of additional capital measures which will counterbalance the unforeseeable

risk of certain activities. According to its critics, the new framework does little to

contain systemic exposure to risks arising from complex combinations of innovative

trading transactions and traditional banking activities (swaps, securities etc).

79 ibid 67-68 80 ibid 71

38

Furthermore, it is alleged that the new requirements failed to provide with a

comprehensive response both to the threat limited sources of funding pose to

sustainable liquidity and to the difficulties in assessing counterparty credit risk. Another

point of which attracted criticism is the fact that in a period when centralisation of

supervision and regulatory coherence are regarded as the only viable solution, the new

regime leaves the calculation of risk weights of certain exposures to national authorities.

An example is the discretion of national authorities in the calculation of the

countercyclical buffer against risk from assets like mortgage-backed securities which

played a central role in the evolution of the crisis.81

Ultimately, despite the criticism it is widely accepted that the new regime addressed

most systemic vulnerabilities which allowed contagion to spread and the crisis to

evolve. Thus, it can be argued that the recommended changes are in the right direction.

Reasonably, the fact that ‘Basel III’ is based on the ‘Basel II’ structure, raises concerns

over its potential to achieve its purpose and it is suggested that reform should have been

deeper since the same areas where already regulated. For this reason, there are many

voices which suggest that regulators should consider additional non-risk-based capital

buffers which supplement risk-based requirements and further guarantee systemic

stability.82

4.2 How has the banking system responded to the news of tighter regulation so far?

In addition to the theoretical approaches in evaluating the impact the new regulatory

framework may have, it is equally important to assess how the banking system

responded in practice.

81 ibid 72 82 ibid

39

One of the main observations is the impact additional capital requirements have on the

cost of borrowing. The findings of numerous studies indicate that stricter requirements

on capital conservation will lead to the increase of lending spreads, which depending on

the jurisdiction will vary between 6 and 15 basis points.83

An empirical research which was conducted by the International Monetary Fund

affirmed the above theoretical estimations. A comparison between the interest rates of

the 100 largest banks has shown that a 1% increase in the capital ratios has brought an

average raise of 0.12% to interest rates. Moreover, the gradual introduction of the

further capital buffers when normal credit conditions are restored is expected to bring

and approximate rise of loan spreads within the range of 16 to 31 basis points which is

translated to an additional rise of loan rates within the same specimen. Those increases

in the cost of borrowing are expected to reduce loans by 2.5%. Even more disturbing is

the fact that this number increases significantly when the estimation is not confined to

the 100 largest institutions. Furthermore, country-by-country estimations present

significant differences in loan reduction depending on the strictness of the capital

conservation policies. A straight forward example is the variation between Canada and

Japan where the same capital requirements were imposed. In Canada loan spreads

remained the same but in Japan they increased by 26 basis points.84

4.3 Can regulation backfire?

The main argument supporting financial regulation is that it safeguards financial

stability. The consequences of deregulation are quite severe and became quite evident

83 Thomas F. Cosimano and Dalia S. Hakura, ‘Bank Behavior in Response to Basel III: A Cross-Country Analysis’ (May 2011) IMF Working Paper 11/119, 3-4 http://www.imf.org/external/pubs/ft/wp/2011/wp11119.pdf accessed on 22 February 2013 84 ibid 5-6

40

by the financial crisis; therefore one might find it relatively easy to argue against it. As

described throughout this research, this reality has triggered during the past couple of

decades a global initiative to over-regulate the financial sector. However, it has to be

underlined overregulation quite often may bring the opposite results.

A hidden consequence of regulation is the cost of implementation and the additional

work it imposes to financial and credit institutions. For example, the Basel

recommendations require the adoption of complex internal risk assessment mechanisms

and specially designated committees. Furthermore, it has been argued that those

requirements have a negative impact on competition, either because their application

varies between jurisdictions or it is easier for larger institutions to implement them.85

Another consequence of overregulation can be drawn from the conclusions of the

aforementioned data regarding the practical impact of ‘Basel III’, especially in the cost

of borrowing. It can be suggested that the imposition of higher capital requirements is

lacking macroprudential perspective since it focuses on securing adequate capitalisation

and liquidity within the financial system, when at the same time it increases lending

rates and transfers shortage of liquidity to real economy.86

Lastly, excessive regulation has proven to create significant incentives for regulatory

arbitrage. It has been observed that the high costs of implementation paralleled with the

profit-seeking appetite of the sector has driven institutions to withdraw from traditional

banking and engage into to new activities, termed as ‘shadow banking’. In measuring

the gravity of the incentive, it has been estimated that a corporation could save $1.6

million when borrowing $1 billion from an institution which evaded the adoption of the

new capital charge. It was the same reasons which caused financial institutions to

85 Charles Goodhart, Philipp Hartmann, David Llewellyn, Liliana Rojas-Suarez and Steven Weisbrod, Financial Regulation: Why, how, where and now? (Routledge 1998) 64-65 86 Cosimano and Hakura (n 6) 6

41

engage into activities involving innovative financial instruments with unforeseen risk

exposure and resulted to catastrophe.87

87 ibid 6; Goodhart (n 85) 63-64

42

5. Conclusive Comments

Since the first Concordat on banking supervision in 1975 the international position

towards banking regulation has changed numerous times and evolved from generalised

directions to a comprehensive framework which includes detailed descriptions of ratios,

models of internal risk assessment and complex mathematical formulas. The vast

difference in depth between the subsequent regimes came as a response to the rapid and

substantial changes the financial system underwent since the Committee’s

establishment. The main idea, however, in all of them was that in a globalised financial

system the answer to instability is regulatory coherence.

The truth is, however, that despite the incremental approach adopted in its

recommendations the Committee failed to prevent the catastrophic consequences of the

financial crisis. Moreover, every regulatory initiative was triggered by a failure of an

institution but all of them were proven insufficient.

With the ‘Basel III’ package, the Committee expects to end this negative tradition. The

new framework promises to implement new policies which will address excessive

leverage, guarantee liquidity and capture risk exposures arising from shadow banking.

Furthermore, the Committee claims the new rules remove the procyclical element of the

previous framework and address systemic interconnectedness in regards to contagion.

The parallel process which was followed within the EU indicates the Union’s

commitment to take all necessary measures which will prevent such crisis from

reoccurring and nullify the chances of further bailouts. Moreover, the new Capital

43

Requirements Regulation represents the Union’s commitment to the idea of banking

integration and promotes regulatory coherence.

Nevertheless, it is necessary to acknowledge that this time the work of regulators faced

much bigger challenges. The consequences of the crisis were severe and the new

framework had to strike a balance between the imposition of stricter requirements which

would guarantee systemic stability and the taking up of policies which would promote

growth and lead the world out of recession.

There have been voices of scrutiny which accuse the new regime on both sides. One

side suggests that requirements had to be stricter and the calculation of capital buffers

independent from the sector’s exposure to risk. In general, the supporters of this view

believe that the reform should abolish the failed concept of measuring capital adequacy

in relation with risk-weighted assets. The other side of criticism proclaims the negative

impact of overregulation by arguing that stricter requirements will increase the cost of

lending and choke real economy.

Under the present financial circumstances and the temporal proximity of the crisis, the

truth is that both arguments sound equally convincing. It is, however, in the present

author’s view that it is very early to extract safe conclusions on the impact of the new

regime. It seems more prudent to allow the new framework to complete its circle of

implementation before deciding over the effectiveness of its capital buffers or its long-

term implications on lending rates. Especially when the three institutions participating

in the EU’s legislative procedure have not reached an agreement over the final texts

which will implement the new regime.

44

All in all, the ‘Basel III’ package can be characterised as a positive step towards

financial stability. However, the ever-evolving nature of banking business requires

regulators to be alert and ready to face new challenges.

1

Table of Statutes

Directives

1. Directive 2009/111

2. Commission Directive 2009/27

3. Commission Directive 2009/83

4. Directive 2010/76

Proposals

1. Commission, ‘Proposal for a Directive of the European Parliament and of the

Council on the Access to the Activity of Credit Institutions and the Prudential

Supervision of Credit Institutions and Investment Firms and Amending

Directive 2002/87 of the European Parliament and of the Council on the

Supplementary Supervision of Credit Institutions, Insurance Undertakings and

Investment Firms in a Financial Conglomerate (Capital Requirements Directive

IV)’ COM(2011) 453 final

2. —— ‘Proposal for a Regulation of the European Parliament and of the Council

on Prudential Requirements for Credit Institutions and Investment Firms

(Capital Requirements Regulation)’ COM(2011) 452 final

2

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6

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