'Light touch' reform proposals for EU banks

This article is based on an analysis by Finance Watch, which can be found here.

At international and EU level, new bank reforms are being introduced to avoid practices that contributed to the 2008 financial crisis, but which have not been reformed so far. Overall, the proposed measures seem to be “light touch” reforms that do not fully protect citizens from financial instability and bank bailouts, as is further explained in this article.

At the same time, the EU’s longstanding reform proposal to ensure that too-big-to-fail banks should never be bailed out with tax payers’ money, the Bank Structure Reform Directive (BSRD), has little chance of being agreed upon. The EU Finance Ministers and the European Parliament were not able to compromise on how basic bank services should be separated from banks’ speculative activities (splitting the banks was never a political option). Some EU countries have introduced their own weaker (France, Germany) or stronger (UK) legislation.

The reform package

The main purpose of a new EU bank reform package, which has been under discussion since November 2016, is to ensure that: (1) the biggest banks that could potentially put the financial system at risk have higher capital buffers, and (2) that banks have less means of manipulating the level of capital buffers they have to hold. In 2008, the financial crisis deepened rapidly because the banks had low capital buffers, as they were borrowing and lending too much (“high leverage”). Since European banks still do not hold high capital buffers — although they do according to existing law — they have been aggressively lobbying to weaken new EU requirements on higher capital. The key issue for the banks is: the lower the capital reserves they can accompany their lending with, the more they can lend and thus make profits. The current low capital buffers of EU banks mean that they are still not robust enough to withstand financial instability and resolve some 1 trillion euros in  bad loans that prevent them from further lending. Political discussions have started how to sell off the bad loans.

The main elements of the EU bank reform proposals are:

  • Thirteen globally systemic risky banks (G-SIBs) domiciled in the EU must issue debt that they do not have to repay or can convert into shares/equity in the event of the bank failing. The banks therefore have to broadly hold a specific minimum amount of so-called eligible liabilities, in line with international standards (total loss absorbing capital (TLAC) (see previous newsletter).
  • All other banks based in the EU, including large international financial groups designated as ‘significant’ or ‘systemically important’, are not subject to TLAC. Instead, they only have to comply with the existing requirements, which are less demanding with respect to the quality of eligible liabilities (minimum requirement for eligible liabilities (MREL)).
  • Supervisors and resolution authorities continue to have significant latitude in deciding whether or not a large EU bank could fail and whether it could then have access to EU or state support. On the other hand, their powers of intervention are being curtailed by a wide range of conditions.
  • All banks must hold a minimum buffer of capital, which cannot be lowered through a bank’s own risk assessment mechanism or strategy manipulation. All banks should have a minimum ‘leverage ratio’ of 3%. This means that they must hold capital of the best quality as a ratio of at least 3% of their total assets, i.e. the sum of all lending provided and financial instruments held by the bank. The riskiest EU banks will not have to adopt a minimum of 5% leverage ratio, as have their peers in the US and Switzerland. The 3% leverage ratio has been criticized by bank experts as being much too low to form meaningful buffers in times of crisis.
  • The ‘standardised model’ on how banks have to assess the risks of a loan has been revised. This standard risk assessment model must be used by (smaller) banks, which do not have permission to use their own risk assessment models. The implementation of this rule in the EU would not be fully in line with the international standard, which makes the EU subject to criticism that it has weakened international standards. For their part, European MPs and regulators maintain that EU peculiarities should be taken into account.
  • The way in which banks calculate risks for trading financial products on financial markets is being updated (‘trading book review’).
  • The European banking supervisory authorities (EBA) are designing specific rules for non-banks, such as big oil companies, that are engaging in speculative trading on financial markets, which should be subject to the same rules as the banks. This is considered a dangerous loophole for trading activities that are as risky as banks or financial players use.

The EU legal proposal that includes the above-mentioned elements (‘Banking Package’) is currently being reviewed in parallel by the Council of Ministers (ECOFIN) and the European Parliament (ECON Committee), and could end up being further weakened if finalised into a compromised legal text later in 2017. This bank reform package inserts the new elements into existing laws (Capital Requirements Directive/Capital Requirement Regulation (CRD IV/CRR), the Bank Recovery and Resolution Directive (BRRD), the Single Resolution Mechanism (SRM) Regulation). For further explanation, see, amongst others, this press release.

Bank reform discussions at international level and in the US

At the international level, the Basel Committee on Banking Supervision is looking into how to limit the use of the banks’ own models to calculate the risks of future loans (i.e. the banks’ “internal ratings-based approach” – IRB). Many official studies have shown that banks abused their own risk assessments models to minimise the capital held against various types of loans, i.e. that each bank calculated the same kind of loan differently. This has resulted in a huge EU-US conflict on potential/new international standards to limit the difference between the standardised risk assessment model and the models used internally by banks. EU banks fear that they will become less competitive because they will have to hold larger capital reserves for mortgages than US banks, which can sell off their mortgage loans to official institutions. However, the real issue is that EU banks still do not hold sufficient capital reserves. The danger is that EU banks will increase securitisation which is still not being regulated although it was instrumental in causing the 2008 financial crisis!

In the US, the Trump administration and large US banks like JP Morgan are proposing measures to change existing US laws so that banks are required to hold less capital. They argue that this will result in more lending to companies and create jobs, which has raised a huge debate. As we saw at the G20 in Baden-Baden, The US has also become reluctant to develop financial reforms at the international level.