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Committee on Economic and Monetary Affairs
16 May 2003
on capital adequacy of banks (Basel II)
Committee on Economic and Monetary Affairs
Rapporteur: Alexander Radwan
PE 323.171
1. The Way to a new capital adequacy regime
The procedure leading ultimately to a new capital adequacy regime in Europe is a rather
complicated one, characterised by lengthy discussions and a number of consultative papers,
working documents, surveys etc. issued since 1999. In the European context, the papers of the
Basle Committee and those of the Commission Services have to be considered. The new
"Basle Accord on banks' minimum capital requirements" will provide a global framework for
internationally active banks. The Commission has to come up with a proposal for a Directive
translating the Basle Accord into EU-legislation.
On 29 April 2003 the Basle Committee issued its third consultation paper in preparation of the
Basle Accord that is scheduled to be completed by the fourth quarter of this year. Results of
the Quantitative Impact Survey 3 (QIS 3), which was conducted 1 October - 20 December
2002 were published on 5 May.
The Commission is about to issue its third consultation document (CP 3), but not before midJune. Although the Commission's approach is expected to closely follow the Basle papers
regarding the overall outline and the majority of the technical details as well (the Commission
participated as an observer in the Basle negotiations), a "one-to-one" translation of the Basle
proposals into European law is neither to be expected, nor would it be desirable.
As it is the Commission's proposal that will ultimately lead to a proposal for a Directive at the
beginning of 2004, and, due to the nature of this subject, so-called "technical details" do
impose political impact, your draftsman regarded it essential to also consider the
Commission's CP 3 in his report on bank's minimum requirements. The report is scheduled
for presentation to the Committee before the summer break, with the adoption in Plenary
scheduled for September, still well ahead of the final completion of the Basle Accord.
This second working paper is not intended to reiterate all the issues tackled in the working
paper that was presented to the committee on 3 December 2002 (DT\480730EN; PE 315.037).
The aim is rather to discuss with colleagues the most recent developments in specific areas,
which showed to entail particular impact on European banks, investment firms and
2. Scope of application
Regarding the scope of application, the European regulation regarding minimum capital
requirements will differ considerably from the Basle Accord. Whereas the Basle Accord is
aimed at internationally active banks that impose risks on the international financial system,
the EU legislation is intended to cover a rather broad range of banks and investment firms.
The recent discussion in the US, which once again made clear that US authorities are planning
to apply the Basle Accord only to a very limited number of internationally active banks,
highlighted the question whether we would need a broad application in Europe.
Although small banks do not represent any systemic risk, it might be necessary to cover them
by the application of Basle II to EU-legislation in order 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.
One important issue in this respect is the possibility of permanent partial use, i.e. the
permission to permanently apply the standardised approach to parts of the portfolio whilst
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applying internal rating based (IRB) approaches to others. The Commission has indicated that
it would be inclined to differ from Basle in this respect. As such flexibility would make life
much easier particularly for smaller banks, I should like to support this view.
Notwithstanding the necessity of a broader scope of application in Europe, there are cases
where the requirement to cover risks by own capital is neither reasonable nor helpful, but
would just lead to further consolidation in the financial services industry. In some Member
States there are thousands of small investments firms, which do not come into possession of
money or instruments of clients (e.g. investment advisers, certain portfolio managers). Their
risks are best covered by insurance.
3. SME financing
3.1. Granularity criterion in the standardised approach
Responding to widespread fears that small and medium-sized companies (SME) would face
worse financing conditions, the Basle committee as well as the Commission have showed
considerable flexibility to take into consideration the special situation of SMEs. For instance,
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 or whether it should be adjusted due to changing market practices or inflationary
The achievements in favour of SMEs were however hampered by the introduction of the socalled "granularity criterion" which relates the exposure to each debtor to the total size of the
retail portfolio. It would further limit the ability of smaller banks to achieve preferential
treatment for their SME loans, as their retail portfolio is simply not large enough to fully
exploit the 1 Mio. € threshold. Although representatives of the Basle Committee have stated
publicly on several occasions that this criterion will be abolished, it is still part of the new
document (see paragraph 44) where it serves as one possibility for national supervisors to
check for sufficient diversification.
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. Thus, the view of the Basle
Committee is not yet perfectly convincing.
Leaving the possibility of a numeric granularity criterion to national supervisors will not
foster an internationally level playing field. The best solution for the European framework
would be to simply not take on board the granularity criterion, neither on the EU level nor as
an option for national regulators.
3.2. Physical collateral
It can be stated that the consideration of credit risk mitigation techniques generally 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. Regarding claims secured by residential
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property and commercial real estate, there seems to be little reason to complain, especially
after the Basle Committee further decreased the risk weight for residential property to 35%
(see paragraph 45). However, other points of concern rermain, e.g. the treatment of physical
collateral. The Basle Committee seems to have a rather restrictive stance on the usage of this
kind of collateral as it remains limited to the IRB Approaches. Especially in the context of
SME financing small banks (which are likely to use the standardised approach) and physical
collateral (as small enterprises usually do not possess considerable financial assets but
physical assets like machinery etc.) play an important role. The Commission may want to
consider a deviation from the Basle paper in this regard and allow for a broad use of physical
collateral even in the standardised approach.
3.3. Start-up financing
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
suffer from limited tangible collateral to cover loans and a very short business history. As
things stand at the moment, unfortunately neither the Basle paper nor the Commission's
documents give any incentives to revive start-up financing.
On the contrary, entrepreneurs might face worse financing conditions as claims on them
might require more own capital in comparison to Basle I. This problem is aggravated as
equity holdings by banks are also disfavoured by Basle II. Other points of concern include the
recognition of physical collateral in the standardised approach, as mentioned above, and the
treatment of guarantees.
Although the new capital requirements do understandably not entail the aim of specifically
supporting economic development we should be well-aware that they do not create additional
barriers to start-up financing, a sector experiencing considerable problems anyway.
4. Covered Bonds
Covered bonds play a significant role in the funding of mortgage and sovereign lending in
Europe. In particular smaller institutions hold considerable amounts of covered bonds as this
instrument proved to be reliable, entails low risk and enjoys liquid secondary markets.
Considering the fact that there have been hardly any problems with covered bonds in most
Member States in recent decades, it is clearly justified to assign a lower risk weight to them
rather than to unsecured claims on banks. Unfortunately, a special regime for covered bonds
is still missing in the Basle papers. The Commission, however, has shown welcomed
flexibility issueing a working paper on the treatment of covered bonds on 7 April 2003. As the
treatment presented in this paper would lead to a much lower risk-weight than the Basle
proposal itself, the Commission is hopefully going to include this view in its final
consultation paper also.
5. Quantitative Impact Study (QIS 3) Results
On 5 May the Basle Committee issued its first official assessment of QIS 3 results. Although
this study was completed by 20 December 2002, data quality problems caused delays in the
analysis and thus in the publication of reliable results.
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5.1. Impact on banks
Concerning the standardised approach, the data shows some increases in capital requirements
relative to the current regime for all types of bank groupings. Increases are most pronounced
for group 1 banks (large internationally active banks). Regarding smaller institutions (group 2
banks), the application of the standardised approach seems to cause some slight increase in
capital requirements whilst the application of the foundation IRB would substantially reduce
capital requirements for those banks. A declared aim of the Basle Committee is, however, to
give only modest incentives to move to the IRB-approach. As IRB entails high costs for
implementation, smaller banks may in practise be forced to use the standardised approach.
The results also show considerable variation in the extent to which capital requirements will
rise or fall under Basle II. For EU group 2 banks the range reaches from + 81% until - 67%.
This means that for some institutions capital requirements will almost double, for others they
will shrink dramatically. Although this reflects the relative risk insensitivity of the current
regime that the new Accord rightly wants to overcome, we should bear in mind that changes
of such an extent call for long transitional periods.
Another point of concern is the sizeable change in capital requirements for some specialised
banks. This is mainly due to the introduction of the new operational risk requirement.
5.2 Impact on SME financing
The main area where minimum capital requirements will be substantially lower is the retail
portfolio. Regarding EU group 2 banks, the reduction will be -7% (standardised approach)
and -18% (IRB foundation) respectively. These results reflect the achievements reached for
retail loans during former consultations. The impact on SME loans seems fairly limited in
comparison (-2% and -5% respectively). It may be worth further assessing why the
achievements reached for SMEs have not lead to greater reductions in capital requirements.
Hopefully the Commission's survey on SME financing can shed some light on this issue,
although its influence on the discussions in Basle might be very limited due to its late
completion (scheduled for the fourth quarter of this year).
It should be born in mind that on the one hand the implementation of Basle II entails
considerable costs for the banking sector that might be passed on to clients, and, on the other
hand, any reduction in credit risk requirements is partly or even entirely offset by the new
operational risk charge. Thus, an adverse impact of Basle II on SME financing can still not be
completely ruled out.
5.3 Procyclicality
The results also seem to reflect the higher risk-sensivity of the new approach. Procyclicality,
which exacerbates cyclical deviations from potential output, might be a direct consequence of
improved risk assessment. The Basle Committee seems to be aware of the danger of
procyclicality as there are discussions to launch a further impact study in 2004. It is
questionable, however, how the results of that study can be considered given the fact that the
completion of the Accord remains scheduled for the fourth quarter of 2003.
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