Basel II update

Last reviewed 10/06/2010: any recent updates in this colour.

Background

After a decade of preparation and discussion, the Basel II capital requirements regime became mandatory for all deposit taking institutions in the EU on 1 January 2008. Basel II was introduced to ensure that lenders' minimum regulatory capital requirements better reflected the risk they run by assessing risk on a much more granular level than Basel I.

However, the financial crisis exposed fragilities in the financial system that it was felt were not adequately addressed in Basel II despite its greater granularity. So the Basel Committee has considered changes to enhance the robustness of the Basel regime while EU policymakers have also sought to alter the framework as it applies in the EU through a series of changes known as CRD2, CRD3 and CRD4.

Changes at the Basel level

At the request of the G20 in response to the financial crisis, on 17 December 2009, the Basel Committee of Banking Supervisors (BCBS) published two consultation papers, BCBS 164 Strengthening the resilience of the banking sector and BCBS 165 International framework for liquidity risk measurement, standards and monitoring. These papers proposed major changes to the capital and liquidity requirements for banks.

BCBS 164 addressed the issues of qualifying capital, counterparty credit risk, the introduction of a leverage ratio and procyclicality. In the EU, the proposals in BCBS 164 were picked up mainly in CRD4 (see below).

Changes at an EU level

The European Union did not wait for direction from the BCBS before suggesting changes to the CRD.

CRD2

The first package of changes, known as CRD2, which policymakers felt were the most urgent, was discussed during 2008, with all the final agreements concluded by July 2009 under the relevant European legislative processes. CRD2 was then published in the official journal on 17 November 2009. The necessary national laws, regulations and administrative provisions required for compliance must be made by 31 October 2010, to be applied from 31 December 2010.

The CRD2 proposals were aimed at improving the:

quality of firms’ capital by establishing clear EU-wide criteria for assessing the eligibility of ‘hybrid’ capital to be counted as part of a firm’s overall capital;
management of large exposures by restricting a firm’s lending beyond a certain limit to any one party;
risk management of securitisation, including a requirement to ensure that a firm does not invest in a securitisation unless the originator retains an economic interest of at least 5%;
supervision of cross-border banking groups by establishing ‘colleges of supervisors’ for banking groups that operate in multiple EU countries;
operation of the CRD by amending various technical provisions to correct unintended errors or to introduce additional clarity sought by stakeholders since the implementation of the original CRD.

Much of this package takes the EU beyond the content of the internationally agreed standards of the Basel Committee, as it is also aimed at achieving greater harmonisation of the single market for financial services.

Proposals were also made within the CRD2 package for improving liquidity risk management. The FSA already introduced a new liquidity risk regime for the UK financial system in October 2009 and to the extent that any modifications are required to implement fully the new CRD requirements, the FSA aims to consult on these by the end of the second quarter in 2010.

CRD3

This package was the subject of consultation by the Commission during Spring 2009 and it began the legislative process in July with discussions in a European Council Working Group under the chair of the Swedish Presidency. Provided that the final European legislation confirms the current timetable, the relevant national laws, regulations and administrative provisions must come into force by 1 January 2011 at the latest.

The European Parliament has yet to vote on the final text and the amendments and timing may be subject to change. The Commission is currently consulting on CRD3 despite the risk of further amendments from the Parliament as it is hoped this will prove useful in highlighting potential changes to industry, whilst recognising the need to consult further if material amendments are made to the current draft directive text.

These changes in CRD3 reflect international developments and build on and mostly follow the agreements reached by the BCBS. They include:

higher capital requirements for re-securitisations to make sure that firms take proper account of the risks of investing in such complex financial products;
upgrading disclosure standards for securitisation exposures to increase market confidence;
A ‘Roadmap’ of responses was agreed by the ECOFIN Council in October 2007, and confirmed by the European Council on 14 March 2008. CP08/22 Strengthening liquidity standards (December 2008) – www.fsa.gov.uk/pubs/cp/cp08_22.pdf6 CP09/29: Strengthening capital standards 3 (December 2009)
strengthening capital requirements for the trading book to ensure that a firm’s assessment of the risks connected with its trading book better reflects the potential losses from adverse market movements in the kind of stressed conditions that have been experienced recently.

CRD3 changes also include rules on remuneration policies and practices to tackle perverse pay incentives by requiring firms to have sound remuneration policies that do not encourage or reward excessive risk-taking.

At its July 2009 meeting, the BCBS decided to extend beyond 2009 the Basel I capital floors, which would otherwise have expired at the end of this year. Consequently CRD3 proposes to amend the CRD so as to extend the floors until the end of 2011.

CRD 4

In February 2010 the Commission published its consultation on CRD4, which closed on 16 April. The consultation, which drew heavily on the latest proposals from the BCBS, sought views on proposed changes in the following areas:

Liquidity standards. Introducing liquidity standards that include a liquidity coverage ratio requirement underpinned by a longer term structural liquidity ratio. These are meant to ensure that banks hold larger cash or near cash buffers and that differences in the maturity of assets and liabilities, which give rise to refinancing risks, are better managed.

Definition of capital: The authorities want to see a rise in the quality, consistency and transparency of banks' capital bases. The financial crisis demonstrated the importance of core Tier 1 capital in maintaining investor confidence.

Leverage ratio: Should a leverage ratio be introduced as a supplementary measure to the Basel II framework? A leverage ratio would set a minimum ratio of capital to total assets regardless of the perceived riskiness of those assets.

Counterparty credit risk: The authorities want to see a strengthening of the capital requirements for counterparty credit risk exposures arising from derivatives, repos and securities financing activities.

Countercyclical measures: It is hoped that a countercyclical capital framework will help to dampen the credit cycle, reducing the likelihood of risks building up during economic upswings.

Systemically important financial institutions: The consultation seeks views on the appropriate measures to deal with the risk posed by such institutions.

Single rule book in banking: As part of the Commission's desire to create a single rulebook (i.e. remove national discretions), it is consulting on the appropriate treatment of real estate lending and more generally on where more stringent requirements might be needed in the CRD.

The Commission intends to present a legislative proposal by the second half of 2010 dealing with some or all of the areas discussed in the public consultation on CRD4 and on amendments to the CRD that was conducted in July – September of 2009.

The Commission has also invited the Committee of the European Banking Supervisors (CEBS) to carry out a quantitative impact study to aid the assessment of the aggregate effect of the proposed revisions.