The European Commission again changes the capital requirement directives for banks. In Brussels last week, it presented a further tightening as a reaction to the inglorious role played by the banks during the financial crisis.
Triumphal march of financial capitalism
In order to be able to understand the significance of the changes to the EU’s Capital Requirement Directives, it helps to take a brief look at recent history. The unprecedented triumphal march of financial capitalism already began in the Eighties of the 20th century. The liberalisation of trade and capital movements was at the very top of the market liberals’ political agenda. The gradual abolition of capital movement controls led among others to the situation that the banks’ traditional credit business was taken over by the trade with securities.

Radical change of the banks’ business model: 25 % yield with small savers?

The politically forced deregulation and liberalisation of the financial markets radically changed the banks’ previous business model. If before, it had been the primary responsibility of the banks to make savers’ deposits available to companies and households in form of credits, banks, during the course of the capital markets’ deregulation, lost their lending monopoly. Today, companies are no longer exclusively dependent on banks to raise capital; they might just as well get money by issuing bonds or shares on international capital markets. At the same time, banks, due to the wealth of alternative investment options, have come under increased pressure to achieve higher yields than in the past. The symbol of this chase for ever higher yields are the statements of Deutsche Bank boss Josef Ackermann, who even amidst the most severe economic crisis of our era does not tire to demand a profit target of 25 % p.a. for his bank.

More yield, more risk: if the going gets tough the state will no doubt come to the rescue
That such profit targets cannot be achieved with classic small savers and investment credits granted to companies is apparent. They can only be achieved by major banks increasingly participating in the global finance casino, taking significantly higher risks than in the traditional credit business. And it is exactly that what they have been doing for many years, unfortunately with the result that the global economy came close to collapse. Only the intervention of the states, using public funds, rescued the banks from collapsing and the small investors from losing their savings. As it turned out, the banks neither had the necessary expertise nor the necessary reserves, which would have justified taking such high risks.

Capital requirement regulations supposed to limit the risk
It is the general idea of capital requirement regulations to set up provisions, which prevent bank clients and the entire financial system from suffering losses because of the irresponsible actions taken by banks. The Capital Requirement Directive of the European Union is supposed to fulfil exactly this purpose. A European (and international) approach in this sector does definitely make sense, if one wants to avoid that one Member State gives a competitive edge to its own credit institutes on the basis of more advantageous regulations. If one, however, analyses the origins of the financial crisis one has to come to the conclusion that the EU regulations did not provide adequate protection. The reason for this among others is the fact that the banks have spent a lot of energy to get round them.

Changes necessary to prevent new financial crisis
To prevent events, which occurred before the financial crisis, from happening again the capital requirement rules have to be changed now. Apart from the question as to how much minimum capital the banks must have as a security for their transactions the changes also concern supervisory procedures and disclosure requirements. The rules are developed by the so-called Basel Committee on Banking Supervision, which is made up of central banks and bank supervisory bodies of 27 countries, and will subsequently be adopted by the EU.

First changes in May 2009 - only fragmentary patchwork
First changes to Basel II - as the regulations are also known as - were already carried out in May 2009. The Austrian MEP Othmar Karas of the European People’s Party was then parliamentary rapporteur of the EP. His report, which was accepted by the plenary in May, recommended among others that major credits to one client could in future only be granted if they would not exceed 25 % of the bank’s capital requirements. This provision should protect the banks from becoming dependent on only a few borrowers. More controversial, however, was the revision of securitisations, which are regarded as being one of the main reasons for the financial crisis. This, however, is a particularly serious “invention” of the financial industry, which not least served the purpose to circumvent the existing capital requirement regulations.

Finance innovations to circumvent the capital requirement regulations

And this is how it works: traditionally banks, when they grant credits, have to keep a certain percentage of the credit volume as a capital reserve. This of course binds the banks’ capital and the money used for that cannot be brought into play for other “more profitable” purposes. The ingenious idea of the financial engineers now was to just pool the collected credits of a bank and to sell them on to interested investors (in technical jargon also “to securitize”). This had several benefits for the banks: on the one hand, the credits vanished from their books in one go, which meant they no longer needed to be secured with capital and the freed capital could now be used for other purposes. On the other hand, selling the credits provided them with new funds, which could also be used for realising profits in the finance casino. As the credits would be sold on in any case, the banks did not feel a great incentive to have a closer look at the credit rating of their borrowers; instead they relied on apparently safe mathematical models, which were used to calculate the statistical probability of default of their borrowers. Both the banks and the buyers of such “credit derivatives” enjoyed their profits for a long time, until the speculation bubble burst and the mathematical models turned out to be wrong.

Securitisations: Parliament and Commission agree on minimal compromise
In order to avoid such excesses in future, Karas proposed in his report that banks should only be allowed to sell loans if they themselves keep 5 percent of the value on their books. Such a percentage excess should be an incentive for the banks to pay more attention to the quality of loans. A controversial request, as in particular the Social Democrats regarded a 5 % percentage excess as too low; they demanded up to 20 percent. In the end, however, the Conservative majority in Parliamentary had its way and the Commission, which had originally demanded 15 percent, agreed with the bank lobby. The sceptics were consoled with the promise that further changes to the Capital Requirement Directives would follow.

Second amendment package: stricter rules for complex financial products
The Commission has now presented its second amendment package, which will be debated by the Member States and Parliament in autumn. It recommends among others that banks, when calculating the capital required for their trading book activities, have to provide for an additional capital buffer for crisis situations and that they apart from this, must not only make provisions for the risk of a total credit default, but also for the deterioration in credit quality (less positive rating). Higher capital requirements and supervisory powers of the authorities have also been recommended for complex re-securitisations. In addition, the banks will be obliged to be more transparent in future with regard to the risks from re-securitisations.

Supervisory bodies should be able to intervene in compensation, but not too much

What is also interesting is the proposed regulation on the salaries of managers and security traders. As it is known, in early summer the Commission had proposed rules in two Communications, which, however, were supposed to be followed on a voluntary basis. Now the proposed amendments to the Capital Requirement Directives of the Commission state that the fundamental principles of these Communications have to be taken into account by the credit institutes. However, the banks contravening should only result in fines; only in very special exceptional cases, will the supervisory bodies be able to oblige the banks to make more capital for risky remuneration and bonus systems available.

Third amendment package in autumn
It will remain exciting in autumn. Then the Commission intends to present further amendments to the capital requirement regulations. The idea is to determine an upper ceiling on the leverage ratio of banks, and the banks should be obliged to “safe up” more capital in good times to have more buffer available in turbulent times (dynamic provisioning).

Further information:

Directive amending Directives 2006/48/EC and 2006/49/EC