EU Banking Reform: The worrying “sotto voce” of the European Commission

The European Commission has today released its revision of the CRR/CRD IV package and the Bank Recovery and Resolution Directive (BRRD). The most remarkable feature of this package is not what is in it – it is the accompanying sotto voce that should give reason for concern.

The package itself incorporates a number of recent international standards, in particular the TLAC Term Sheet and new Basel Committee rules on capital adequacy. It is notable primarily by its lack of ambition and a distinct readiness to deviate from the international standard in recognition of European peculiarities. On a more general note, however, these exceptions – and the explanatory notes – highlight an overriding concern about maintaining or improving the competitiveness of EU banks vis à vis overseas rivals and providing incentives to stimulate credit creation. We note, in particular:

  • Recent amendments to the Basel Committee’s international capital standards, notably the new Standardised Approach for Credit Risk and the Fundamental Review of the Trading Book, have been incorporated and existing peculiarities of the EU implementation, e.g. regarding sovereign risk and mortgage lending, maintained.
  • The leverage ratio, a more conservative measure of capital adequacy that is less susceptible to manipulation than the risk-weighted assets (RWA) approach, has been introduced at its baseline level of 3%. Suggestions by the Basel Committee to introduce a higher level for systemically important banks (up to 5%), already the prevalent practice in other major jurisdictions, have not been incorporated so far. The standard also includes a number of modifications that allow banks to exclude particular exposures, such as certain derivatives, from the metric.
  • The global standard for Total Loss Absorbing Capital” (TLAC) has now been incorporated, broadly in line with the FSB Term Sheet, and will be binding upon the thirteen EU-domiciled global systemically important banks (G-SIBs) only. The remaining banks, including most of the large international banks under the direct supervision of the ECB, will only need to comply to the – more lenient – European MREL (Minimum Requirement for Eligible Liabilities) regime. Whether so-called “significant” or “other systemically important” banks can be resolved safely remains now primarily in the hands of the resolution authorities.
  • Unlike TLAC, the new MREL rules allow, for instance, the inclusion of structured notes and do not mandate eligible liabilities to be subordinated to other senior unsecured claims. It is left to the resolution authorities to argue the case for subordination on a case-by-case basis.
  • The Commission has announced recently that it is looking to create a new category of “senior non-preferred” debt available for bail-in. We note that loss-absorbing debt and hybrid instruments are already available under the current rules, in the guise of AT1 and Tier 2 capital. Whatever funding cost benefit banks are expecting from issuing creative new instruments will come, no doubt at the expense of more complexity and less legal certainty. It is certainly no contribution to making the ‘bail-in’ tool simpler and more reliable.
  • In Art. 55/2.b. BRRD Member State resolution authorities are now free to waive the requirement for banks to include bail-in clauses in third-country liabilities. It is regrettable, in our view, that EU institutions have not been able to come to an arrangement with their relevant third-country counterparts. No doubt the resultant loophole will be seized on thankfully by creditors eager to immunise their claims against the event of a bail-in.
  • For all the increasing responsibility that has been placed on the supervisory and resolution authorities, in particular, the new package is going out of its way to curtail their discretionary room for manoeuvre in setting (Pillar 2) capital adequacy and higher MREL requirements. In order to disprove what appears to be an implicit suggestion of “gold plating” the common standards, authorities now effectively have the burden of proof to justify additional requirements on a case-by-case basis. They should, in particular, be strictly limited to micro-prudential considerations and no longer mandated to address potential concerns related to systemic risk.

The package already betrays the impact of months of incessant lobbying by the European banking industry –even before the very public trans-Atlantic falling-out over the latest round of Basel Committee proposals – dubbed ‘Basel 4’ by its detractors. The climate of international co-operation in banking regulation has become frostier and policy appears to be driven increasingly by domestic priorities. Given the global interconnectedness of the financial system this is a dangerous path to follow. So far, the Basel process has, for all its shortcomings, been the best hope for tax-paying citizens to be shielded from the fall-out of the next major banking crisis. We can only hope that politicians and regulators continue to engage constructively in this process in the interest of improving financial stability and the resilience of the global banking system.

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