European member states agree on stricter bank capital requirements after UK accepts late concessions

Out-Law News | 17 May 2012 | 1:04 pm | 2 min. read

EU member states have unanimously adopted stricter capital requirements for their banks after the UK was granted a late agreement enabling it to implement its proposed ring-fencing of banks' retail and investment activities in full.

It is expected that the new rules, which must now be negotiated with the European Parliament, will be in place by the end of June. This would result in the 27-country bloc becoming the first area in the world to implement the international banking agreement known as Basel III.

In a statement, the EU's Economic and Financial Affairs Council said that the rules would aim to increase financial stability by making banks better equipped to manage their risks and absorb the impact of another economic crisis, while at the same time contributing to sustainable economic growth by harmonising rules throughout the single market.

The Council has proposed draft legislation in the form of a directly-applicable Regulation (834-page / 2.5MB PDF) requiring all EU banks to hold top-quality 'tier one' capital worth 4.5% of their risk-weighted assets to cover unexpected losses. Member states will be given additional powers to raise prudential requirements for their own authorised institutions and to increase risk weighting up to 25% on certain transactions, including residential and commercial property and intra-financial sector exposures.

An additional draft Directive (220-page / 686KB PDF) provides for two further capital 'buffers' above the minimum requirements. Banks will have to maintain a 'conservation buffer' equivalent to a further 2.5% of their risk-weighted assets to be able to pay out dividends or bonuses, and set a 'counter-cyclical buffer' specific to the institution to prevent excessive lending. Member states will also be able to impose a further 'systemic risk buffer' of up to 5% on the financial sector, in whole or in part, in order to deal with systemic risks with the option of a higher percentage if approved by the Commission.

The concession will allow the UK to apply stricter standards to retail than investment banks once its proposed 'ring fencing' reforms take effect without seeking specific Commission approval,, providing the buffer applies consistently to exposures in the UK and elsewhere in the EU. The Independent Commission on Banking (ICB) previously indicated that the UK's large retail banks should hold tier one capital of at least 10% of their risk-weighted assets, stricter than the level proposed under both the European proposals and Basel III itself, which calls for a 7% buffer by 2019. Tier one capital consists in the main of shareholders' equity, disclosed reserves and other high quality assets.

The Basel III reforms will see more stringent capital requirements for banks phased in between 2013 and 2022. Banks will have to increase both the quantity and quality of capital they hold, while accounting for higher levels of risk-weighted assets. The international agreements apply to only about 120 "internationally active" banks, however the EU intends that its provisions will apply to all 8,300 European banks.

"Our overall objective remains to strengthen the resilience of the banking sector in the EU while ensuring that banks continue to finance economic activity and growth," said Michel Barnier, EU Internal Markets Commissioner. "The final compromise must contribute to financial stability, the necessary basis for growth and employment."

The draft legislation will also introduce a UK-wide liquidity ratio from 2015, with the option of a further leverage ratio from 2018. The liquidity ratio refers to the percentage of a bank's high-quality assets it can readily convert into cash during a specified 'stress scenario', while the leverage ratio will allow regulators to limit the amount that banks are able to borrow. Stronger governance and supervision requirements are also proposed, which will give authorities the option of imposing sanctions against banks if the rules are breached.

The European Parliament has also unanimously backed stronger capital requirements as part of a package of measures which also include the "right balance" of reducing the risk banks assign to lending to small businesses and limiting bonuses to the amount of bankers' fixed pay. Banking law expert Tony Anderson of Pinsent Masons, the law firm behind Out-Law.com, pointed out that any concessions on lending to small businesses would still need to reflect "the commercial reality of making such loans".