Background
The original Accord, Basel I, was agreed in 1988. This stipulated that banks have to have enough funds to cover potential losses from transactions (technically, a bank's total capital should never fall to a level of less than 8% of risk-weighted assets), and set out rules for calculating the risk-weighted figure.
But in a world of interconnected financial systems, it has been recognised that a single risk measure for all banks is no longer appropriate, hence the new Accord, Basel II. This is more risk-sensitive and flexible than its predecessor – and more onerous.
Banks are now expected to examine IT, security, fraud, employment practices and workplace safety, business services, physical damage, business disruption, system failure, service execution-delivery-process management, and legal and reputational factors.
While the UK, as a member of the Basel Committee, is required to comply with the new Accord anyway, Basel II will also be incorporated into EU law.
The existing European legislation (originally the Solvency Ratio Directive of 1989, now incorporated in the Codified Banking Directive of 2000) was based on the Basel I Accord. It applies to all banks and investment firms in the EU and needs to be updated in order to reflect the changing regulatory climate.
In order to maximise consistency between the EU legislation and the international framework, the European Commission and EU members of the Basel Committee have therefore been keen to ensure the suitability of Basel II for application in the EU Single Market.
Accordingly, the new Basel agreement represents the appropriate basis for the proposed EU Directive on a new capital requirements framework. At the same time the draft Directive has been designed to fully reflect the specific features of the European context – in particular its application to the full range of financial institutions including banks of all sizes and levels of complexity and investment firms.
Draft Directive
According to the Commission, instead of the current 'one-size-fits-all' approach, the proposed new framework would consist of three different approaches, allowing financial institutions to choose the approach most suited to them: simple, intermediate or advanced. The simple and intermediate approaches would be available by the end of 2006 (but banks could still opt to apply the current rules until end 2007) and the most advanced approaches from the end of 2007.
Changes to existing legislation include:
Capital requirements would become much more risk-sensitive. They would be far less crude than in the past and better cover the real risks run by the institution. This would enhance consumer protection and financial stability and lead to more efficient capital allocation.
Capital requirements would be more comprehensive than in the past. In particular they would be expanded to cover 'operational risk' (such as the risk of systems breaking down or people doing the wrong things). This is an increasingly important risk for financial institutions.
The new rules would comprise a new 'supervisory review process' (the so-called 'Pillar 2'). This part of the framework would require financial institutions to have their own internal processes to assess their capital needs and call for supervisors to evaluate institutions' overall risk profile to ensure that they hold adequate capital.
The new rules would also require credit institutions to disclose certain information publicly in order to increase the levels of 'market discipline' supporting the soundness and stability of financial institutions (the so-called 'Pillar 3').
Finally, the new framework would enhance the role of the 'consolidating supervisor' responsible for the top-level of supervision of an EU cross-border group – i.e. the national supervisory authority in the Member State where the group's parent institution is authorised.
This role would now include new responsibility and powers in coordinating the supervision of cross-border financial services groups. This would include coordinating the treatment of an application by such a group for approval to use the more sophisticated capital calculation rules made available by the proposed Directive.
All supervisors concerned in such an application should reach an agreed decision on the application within six months. In the case of failure to do so, the consolidating supervisor would be empowered to make a decision.
In addition, specifically designed rules on capital requirements for financing small and medium-sized enterprises would mean lower capital requirements for lending to such institutions and preferential treatment for certain types of venture capital.
The new framework also recognises the lower risks associated with retail lending to individuals – both for general purposes and for house purchasing – by introducing lower capital requirements for these types of lending.
According to Internal Market Commissioner Frits Bolkestein:
"This proposal will put the EU at the forefront of modern financial regulation. It will enable European financial institutions to do business efficiently, safely and competitively to the benefit of consumers, businesses and Europe's economy. It is an excellent example of international and European processes working in parallel to produce positive results for all."