Bankers worried EU may not meet 2004 deadline

European bankers fear it will be touch-and-go whether the European Union will meet its 2004 deadline for introducing new capital adequacy rules for EU banks and investment firms.

And some are worried that even if the deadline is met, the legislation won’t be flexible enough to deal with the evolution of the operational risk capital charge. A charge for op risk will for the first time form part of the capital banks will have to set aside as a guard against the risks of the banking business.

If the deadline is missed because of the widely acknowledged slowness and inflexibility of EU lawmaking, it could put European banks at a competitive disadvantage in relation to their counterparts in other major economies.

Financial Services Authority (FSA) chairman Howard Davies warned in April that timely action was needed by the EU to ensure the new rules could be implemented in EU member countries by 2004. The FSA is the UK’s principal financial watchdog organisation.

Overlap
The problem stems from the parallel development of the new banking rules in both the 15-nation EU and the 11 countries of the so-called Group of 10 (G-10) leading economies. Seven EU countries - Belgium, France, Germany, Italy, the Netherlands, Sweden and the UK - are also G-10 members.

EU sources say the coming into force of the European Commission’s new capital adequacy directive - known as CAD 3 - should take place "sometime in 2004".

They say the commission is preparing a legislative proposal that it aims to adopt by the end of this year. The European parliament and council will then have 18 months to adopt CAD 3. EU member states will then have a further year to in which to bring it into law, say the sources.

The new rules originated from the Basel Committee of banking supervisors from the G-10 countries, the body that in effect regulates international banking. They are designed to be more risk-sensitive than the current rules that stipulate how much capital large international banks must set aside as protection against banking risks.

Basel II
The new rules - known as Basel II - will link the size of capital charges to a bank’s performance in managing risk. Banks with the most efficient risk management systems will enjoy lower capital charges than less efficient banks.

Basel II will also for the first time require banks to set aside capital against losses from operational risks such as fraud, computer system failure and trade settlement errors.

CAD 3 is closely modelled on Basel II, the final version of which is expected before the end of this year, following a period for industry comment that ends on May 31.

The intention is that Basel II and CAD 3 will come into force in 2004. The exact date in 2004 has yet to be decided. But bankers believe Basel Committee chairman William McDonough, who is also president of the New York Federal Reserve, is aiming for January 1, 2004 for Basel II. The EU, say bankers, seems to have a target of spring 2004.

A three-month gap between target dates would not matter, European bankers say. But if EU banks were stuck with the current Basel I capital code due to the EU’s CAD 3 laws lagging substantially behind, critics fear many European banks could be burdened with higher capital charges than their rivals in non-EU G-10 countries.

Hence competitor banks in Canada, Japan, Switzerland and the US could end up with lower costs because they could have lower capital charges under Basel II.

The FSA’s Davies pointed out that the 2004 start date for Basel II is itself a concession granted to the EU members of the Basel Committee by the non-EU members. The non-EU members, unencumbered by the EU legislative process, wanted an earlier start.

Inefficiency
But Davies fears CAD 3 legislation could fall foul of the "cocktail of Kafkaesque inefficiency", as it was described in a February report by a committee chaired by Alexandre Lamfalussy. Lamfalussy is seeking to speed secondary legislation on European securities markets through the European decision making process.

"While Lamfalussy was reporting on securities regulation, it is difficult to argue that prudential [banking] regulation in the EU is entirely free of the same problems," Davies told a London conference on Basel II organised by the FSA. The Lamfalussy report noted that the EU took four years to pass the comparatively simple Basel I legislation.

Critics fear EU legislators will remain reluctant to grant financial regulators flexible powers to alter subsidiary financial regulation without reference back to the legislators in the light of experience.

Richard Metcalfe, London-based assistant director of European policy at the International Swaps and Derivatives Association (Isda), says: "It will be a tall order for the EU to hit the 2004 deadline for a start, and a further problem to get an op risk charge that’s suitable." Isda is the trade body for the international derivatives and risk management industry.

Flexibility
Flexibility of rules will be a crucial factor in the success or failure of Basel II and CAD 3, argue critics.

That’s particularly true of the op risk charge, says Metcalfe, which has yet to be calibrated by Basel regulators who have only just begun to collect the relevant loss data on which to base the charge. Basel regulators acknowledge that the structure and the amount of the charge will have to be refined over time.

Metcalfe believes the problem could be solved by attaching annexes to CAD 3 that allow European regulators to make changes to the structure of the op risk charge without reference to legislators. But he says it’s an open question whether the amount of the charge would be covered in the same way.

Meanwhile, Davies says that if the EU timetable were to slip, it is conceivable that when the FSA publishes its final rules, it would have to include the warning that they are subject to change by the EU parliament and council.

"In other words," he says, "in order to deliver on time, we shall have to take the risk that things change at a late stage".Operational Risk