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Western EuropeSeptember 1 2011

Is CRD4 too far, too soon for a fragile Europe?

The European Commission has finalised its proposal on the fourth iteration of the Capital Requirements Directive. It makes the EU the first jurisdiction to pass into law the Basel III rules agreed last year. Nobody is surprised by the content, which still has to be passed by the European Parliament and the EU's member states, but many are still worried about the impact it may have while European economies remain fragile.
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What is it?

The European Commission's (EC) draft proposal on the fourth Capital Requirements Directive (CRD4). The proposal, which still has to be approved by the EU's 27 member states and the European Parliament, makes the EU the first jurisdiction to begin implementation of the global Basel III and liquidity guidelines that were adopted last year.

What are the main provisions?

In terms of capital, the measures put European banks in line with Basel III in requiring them to hold common equity Tier 1 capital of 4.5% and total Tier 1 capital of 6%, up from 2% and 4% under the current regulatory regime.

According to estimates from the EC, this will require them to raise about €460bn in extra capital by 2019 or shrink their balance sheet and shed risky assets. However, the new regulation will come into force gradually, with banks only having to reach full capital levels in 2019.

The EU will force all 8200 banks and investment funds based in the bloc to stick to the new capital requirements. By contrast, the US, which has promised to implement the Basel III rules, will make only the 20 biggest lenders apply the rules.

What's in the small print?

As well as introducing capital requirements, the proposed directive also seeks to break the 'mechanistic' reliance on credit ratings. The proposal says banks and investment funds must have internal credit decision processes in place. This applies irrespective of whether banks grant loans to customers or whether they incur securitisation exposures.

CRD4 also aims to improve corporate governance, with a focus on creating a gender balance to improve board diversity. The proposal aims to avoid 'group think', saying management boards should be made up of executives who differ in their age, gender and geographical background.

What does the industry say?

Some countries, including the UK, are still fighting for the flexibility to introduce national requirements that may be higher than the EU requirements. Banks are worried that this 'gold-plating' will lead to an uneven playing field even in Europe.

“There are a number of outstanding issues with CRD4. One of the biggest is whether the final requirements will include maximums as well as minimums for capital and liquidity, which will prevent national regulators from gold-plating in their domestic markets. From a firm's point of view, the more that is common across Europe, the better. Differences between countries could create the potential for substantial regulatory arbitrage and serious difficulties for those groups that operate across multiple jurisdictions," says Patricia Jackson, head of financial regulatory advice at Ernst & Young.

Banks are also concerned with timing. Industry groups in the UK and Germany have warned that if the EU moves too far ahead of the rest of the world, its banks could lose out to international competitors and this will result in less lending to the real economy.

The projected capital shortfall, equivalent to 2.9% of all the EU banks’ risk-weighted assets, helps explain why EU banks are among the fiercest critics of the Basel III proposals.

What about the deadline?

Some analysts have been critical about the long deadlines given to banks to reach the desired capital levels, saying that the weakness of the EU banking system has been central to the failure of EU policy-makers to reach a speedy and decisive resolution to the eurozone crisis.

Others argue, however, that this timetable is meaningless, because against the backdrop of the eurozone crisis, markets will require banks to increase their capital levels before the regulatory deadline.

What do the regulators say?

EU internal market commissioner Michel Barnier, who hailed CRD4 as a “highway code” to police European banks, argues that the measures will benefit Europe in the long term. When he formally proposed the directive at the end of July, Mr Barnier drew an analogy to improvements in road safety. “One cannot improve road safety by not acting to address all the risk factors. If one single driver lacks vigilance or one single rule is not properly implemented, catastrophe can strike everybody,” he said.

Taking the analogy a step further, he said that the higher capital requirements would establish “stringent road traffic regulations”, with reinforced sanctions for wrongdoers acting as a metaphoric police force. Crucially, he said that the requirements would reinforce the “need for sobriety”, something that was often lost in the years before the financial crisis.

Could we live without it?

Reg Rage Sept 2011

Not really. But bankers and others are worried that other elements of the directive, including liquidity and leverage rules that limit the size of a bank's total balance sheet relative to its equity, will combine to have unintended consequences.

“With the European economy in such a parlous state, regulators should be careful about taking such steps as they could have drastic knock-on effects on their ability to help drive economic recovery,” says one banker. 

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