EUROPEAN PARLIAMENT
1999
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2004
Committee on Economic and Monetary Affairs
2 December 2002
WORKING DOCUMENT
on banks' minimum capital requirements (capital adequacy)
Committee on Economic and Monetary Affairs
Rapporteur: Alexander Radwan
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1. Background and time schedule
Regarding capital adequacy, the discussion in the Basle Committee as well as the
Commission's papers on that issue have to be considered. The new "Basle Accord on banks'
minimum capital requirements" will provide a global framework for internationally active
banks and the Commission has to come up with a proposal for an EU-Directive that translates
the Basle Accord into EU-legislation. So this working paper refers on the one hand to the
Quantitative Impact Survey 3 documents (technical guidance and the corresponding overview
paper) issued by the Basle Committee on Banking Supervision, and on the other hand to the
Commission's "Working Document on Capital Requirements for Credit Institutions and
Investment Firms."
The Quantitative Impact Survey 3 (QIS 3) was launched on 1 October 2002. It is to gauge the
impact of the second consultation document that was issued January 2001 and revised in
December 2001. Banks are asked to submit their findings by 20. December 2002. QIS 3
reflects the agreement on a number of important issues, which was reached by the members of
the Basle Committee on 10 July 2002. Therefore it represents the most recent stage of the
process which should lead to a new Capital Accord to replace the current Accord of 1988
until the end of 2003 (implementation by national legislators by 2006). Although the
discussion since 1999 (initiated by the Committee's first consultation document) has reached a
rather mature stage, the QIS 3- documents cannot be regarded as a direct guidance to the New
Basle Capital Accord for there will be a further round of consultation starting in the second
quarter of 2003.
The Commission’s services issued a "Working Document on Capital Requirements for Credit
Institutions and Investment Firms" (18.11.2002) to prepare the last (third) round of
consultation. It will be conducted in spring/summer 2003, roughly running in parallel with the
third Basle consultation paper. A proposal for a directive is expected to be launched at the
beginning of 2004.
As the European Parliament was not officially involved in the Basle process, it is of utmost
importance to make clear our point of view in the ongoing process of implementation the new
Basle Accord through an EU-Directive.
2. Overall assessment
Proper risk assessment on the micro-level is extremely important for the stability of a banking
system. Hidden risks in banks' portfolios can lead to a vicious circle and unpredictable
contagion when such a weak financial system is hit by adverse developments. The Japanese
case provides a deterrent example. Thus the overarching goal of the new Accord, to foster
improved risk assessment of banks, is welcome. To what extent this goal can be reached by
the current approach and what costs it causes (costs of implementation, negative side effects)
is a question far from being settled. This working paper shall contribute to the discussion.
Indeed many open questions remain. One field of concern is the micro-economic impact on
small banks and small-/medium-sized businesses (SMEs); other problems relate to unwanted
implications on the macro-level, mainly the threat of procyclicality. This working paper will
tackle all of these issues.
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But at first it should be pointed out that the whole process leading to the new Basle Accord is
problematic from the viewpoint of democratic legitimation. The European Commission
participated just as an observer in the Basle negotiations and the European Parliament as well
as national parliaments were not officially involved at all. There are serious concerns if the
creation of agreements like the new Basle Accord, which set preconditions for legislation,
should in future be left completely to "technical" committees like the one in Basle. The
Herstatt crisis in 1974 led to the establishment of the Basle Committee. This event showed the
very urgent need for a prompt reaction and the necessity to develop international standards to
contain negative spillovers in the financial sector. Thus the character of the Basle Committee
as a rather technical gathering of supervisory authorities and central banks (mainly of the G10 countries) might have been justified at the time, but nowadays we should foster democratic
legitimation and transparency. The roles of the European Commission, the EZB and
especially democratic control by the European Parliament in negotiations of that type must be
clearly defined.
A special challenge will be the question of how to implement the new Basle Accord in EUlegislation. At the moment there are serious attempts to extend the Comitology procedure to
all areas of financial regulation. This procedure separates principal political questions (level
1) from rather "technical" rule-setting (level 2). Under the Lamfalussy-type Comitology
procedure, which is currently applied to securities legislation, Parliament is involved only at
level 1. It should be noted, however, that it is often extremely difficult to distinguish between
"technical" questions (level 2) and issues of political impact (level 1).
According to the Commission's Working Document on capital adequacy regulation, the
European Parliament, in the adoption of the initial Directive, is given the right to vote on the
content of the annexes and thus does have the ability to influence the technical details. Future
amendments to the annexes, however, are supposed to be subject to the Comitology
procedure. As Parliament has at the moment no formal right to influence any such
amendments, it would be clearly unacceptable to leave any issue of a potential political
impact to level 2. Parliament needs a formal call-back-arrangement and a clear amendment of
Art. 202 of the Treaty to ensure Parliament's democratic control also at level 2.
The new Basle Accord principally has a three-pillared structure i.e. 1. Capital requirements, 2.
The supervisory review process (intensified quality banking supervision) and 3. Market
discipline via enhanced publication obligations. However, as concerns the second and the
third pillar, suggestions are still in a comparatively preliminary state. This working paper will
therefore focus on questions regarding capital requirements, especially the assessment of
credit risks and its impact on the micro- and macro-level.
3. Impact on the banking system
The Basle Accord is aimed to cover internationally active banks that impose risks on the
international financial system. It should be noted, however, that certain types of securities
firms in the USA are not covered by the current Basle proposal even though they perform
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activities, which are regarded as banking activities in most European countries. Considering
their market position and their role in financial markets, they do impose risks to the
international financial system. Such a different treatment of banks in the USA and Europe is
not going to foster an international level playing field.
In some EU countries, small local banks play an important role. Although they do not
represent any systemic risk, they should also be covered by the application of Basle II to EUlegislation to ensure a level playing field as foreseen in the Commission's Working
Document. It must be ensured, however, that regulatory cost arising from the new legislation
remains manageable for small institutions. A further consolidation in the banking industry
induced by the new capital requirement scheme must be avoided. The main issues in this
respect are possible differences of capital requirements between the standard and IRB
approaches measuring credit risks.
In the standard approach, the capital requirements regarding credit risks are measured using
the (debtor) evaluation of rating agencies. As the rating agencies play an increasingly
prominent role in banking and finance, the question arises how to make sure that they act
independently meeting appropriate quality standards, especially given the fact that there is
very limited competition in this field.
Alternatively, however, it will be as well possible to apply bank-internal rating systems (IRB
approaches), which come in a foundation and an advanced version. This should prevent a
systematic drawback for those countries where the recourse to rating agencies is less
prevalent.
The IRB-approaches are feasible only for banks that conduct a certain amount of transactions
as they entail substantial fixed-costs elements. Due to high costs for the implementation of
more complex modelling some small local banks may be forced to follow the standard
approach unless they can use systems provided by their associations (as might be an option
for savings banks and co-operative banks). The Commission seems to have developed a more
flexible approach regarding the "partial use" of IRB-measures than the Basle Committee. The
"partial use"-option would substantially simplify the implementation of IRB-measures for
smaller banks. A declared aim of the Basle Committee is to give only modest incentives to
move to the IRB-approach. QIS 3 has to prove that banks applying the standard approach
have indeed no substantial disadvantage in terms of capital requirements.
This is especially important as the IRB approaches still leave some substantial questions.
There are indications that the present calibration still underestimates low frequency, high
severity losses that are of course of special interest to prevent banking crises. Additionally,
the very limited consideration of risk diversification (portfolio-effects) instead of just
summing up risks separately tends to relatively overestimate the risks of small loans. This
argument is still justified despite of the fact there has been some progress in this respect, at
least regarding SMEs.
Concerning operational risks (OR) the Commission seems to have developed a stance more
open towards the use of insurance. Especially for small banks, life will be much easier under
the new regime, if they have the opportunity to cover against OR by using insurance. Such an
alternative would be clearly welcome.
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4. Impact on small and medium-sized enterprises (SMEs)
Responding to widespread fears, small and medium-sized companies (SMEs) would face
worse financing conditions, the compromise reached in Basle tries to take into consideration
the special situation of SMEs. Credits to SMEs up to 1 Mio. € are included in the regulatory
retail portfolio when certain conditions are met. That means lower capital requirements in the
IRB approaches as well as in the standard approach, where a risk weight of just 6% is
attributed. It might be useful to have an in-depth discussion with market participants as to
whether the 1 Mio. € threshold is appropriate. Under the IRB approach, credits to enterprises
up to 50 Mio. € in sales are measured by using a preferential risk curve that takes into
account, that a portfolio of many small credits is less risky than one huge credit to a single
company. A possible setback in this respect is the "granularity criterion" introduced in the
standard approach, which can be found in QIS 3 as well as in the Commission's Working
Document (Art. 28/3). This criterion relates the exposure to each debtor to the total size of the
retail-portfolio. There is the danger that some of the achievements in favour of SMEs are
offset by this additional criterion for the retail portfolios of smaller banks are not large enough
to fully exploit the 1 Mio. € threshold for a single retail loan. As the Basle Accord is aimed at
internationally operating banks, it would not make sense to levy any additional burden on
smaller institutions that are doing business only on a local level and do clearly not impose any
risk to the financial system.
Relations between small local banks and SMEs often have a long-term view and take into
account "soft facts" which can hardly be covered in quantitative risk assessments, e.g.
management quality. There is no need to urge banks to cut business relations, which have
proved being successful in the long-term. Especially in the current situation of global
economic downturn, the difficulties of SMEs to obtain funds should not be intensified.
Without doubt the treatment of loans to SMEs has been significantly improved compared to
the first approaches of the Basle Committee. However, QIS 3 and the Commission's survey on
SMEs might provide further assessment on the impact of Basle II on SMEs financing. As the
Commission's survey will not be available before autumn 2003, its influence on the
preconditions set by the Basle Committee might be, however, limited.
It can be stated that the consideration of credit risk mitigation techniques broadens the use of
collateral and tends to lower capital requirements. In the context of SME-financing certain
types of collateral play a dominant role, e.g. claims secured by commercial real estate in some
EU-countries. The Basle Committee seems to have a rather restrictive stance on the usage of
that kind of collateral, claiming that in some countries commercial property lending has led to
troubled assets in the banking industry. Preferential risk weights for loans secured by
commercial real estate can be applied by national authorities (when certain conditions are
met). It is not reasonable to make this decision on the EU-level, as there are big differences in
the structure of commercial property markets within the EU, with some countries having
highly volatile, others rather steady developments. On the contrary, this is a good example
that it makes sense to leave some of the options and latitudes of the future accord to national
authorities. The approach of the Commission to leave the decision on a preferential treatment
of commercial property collateral to national authorities is certainly sensible.
In the current situation banks are fairly restrictive regarding start-up-financing. This threatens
technological development and future growth prospects to a considerable extent, especially in
those Member States where venture capital financing is not yet fully developed. Entrepreneurs
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suffer from limited tangible collateral to cover loans and a very short business history.
Unfortunately, neither the Basle paper nor the Commission's documents give any incentives
to revive start-up financing.
5. Impact on the business cycle
A serious critique regards the systemic consequences of the new capital adequacy regime, that
is, it concerns macro-prudential problems. Procyclicality, which exacerbates cyclical
deviations from potential output, might be a direct consequence of improved risk assessment.
In a cyclical downturn the risk related to loans typically rises and might force banks to cut on
credit lines, thus deepening the recession. As a result of the certification process of internal
models, a homogenisation of credit evaluations might evolve and worsen procyclicality. In
times of crises these factors could lead to further, regulation-induced destabilisation.
Of course, it is in no way a solution to hide risks in the credit portfolio. Insofar, the
overarching goal of Basle II, a better assessment of risks, is principally to be welcomed. But
we should be very careful that the capital requirements are not going to worsen a cyclical
downturn by amplifying boom and bust cycles.
The calibration of risk assessment has already been amended in a way to reach a more
balanced development. The ECB brought up the idea to develop incentives for banks so that
they build up capital buffers in a cyclical up-swing that damp the danger of a credit crunch
during a downturn.
We should further assess the impact of the new regime in this respect. A regulation too rigid
is simply not reasonable. The new regulations should provide a flexible framework, open to
amendments which call for implementation due to practical experience. This also means,
there should be a review of the new regulations on a regular basis. The European Parliament
must not be excluded from this debate and thus Art. 202 of the Treaty must be amended
including a formal call-back-right for the Parliament. Unless Art. 202 is amended accordingly,
any extension of the Lamfalussy Comitology procedure on the implementation of the Basle
Accord into EU-legislation would be unacceptable for Parliament.
6. Impact on long-term business relations
The new accord might have an impact on the term-structure of business relations as banks
using the IRB approaches will be in principle required to incorporate maturity adjustments
calculated on a mark-to-market methodology. Supervisors will, however, have the opportunity
to exempt smaller domestic firms (consolidated sales and assets of less than 500 Mio. €). This
exemption is included in the Commission's paper as well.
In this respect, several points have to be considered: Debtors have already to pay a risk
premium to convince creditors to long-term lending. The term premium and the default
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premium are part of the yield curve. So it is questionable, if the new accord should give any
further incentives to shorten the average maturity of lending. Additionally, the average
maturity of lending might shrink anyway due to the new accord as banks are unwilling to
lending out long-term when they perceive any danger of a debtor's internal or external rating
worsening.
Short-term financing showed to have a serious negative impact on the stability of the financial
system in the case of crises and should not be encouraged by regulation.
7. Supervisory review process
Pillar II (supervisory review process) and Pillar III (market discipline) are, in comparison with
Pillar I, in a more preliminary state. They are not part of QIS 3, and also in the Commission's
Working Document they remain quite short with many articles still not filled.
Nevertheless, the ongoing discussion has provoked some remarks from market participants,
which should be taken into consideration. Regarding pillar II, they fear the danger of banking
supervision very prone to intervention and uneven application across countries. The
Commission is therefore asked to come up with more detailed proposals on how to reach
supervisory convergence.
The Commission seems to support a flexible application of the SRP, taking into consideration
a bank's size and structure. Regular and intense on-site inspections make sense in the case of
big, complex institutions that do impose risks to the financial system. Small institutions could,
however, be subject to a lighter regime. The aim of a level playing-field and the concept of
subsidiarity should be married in the best way possible.
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