European Banks Prepare for Possible Basel III Redux

It has been said, “Those who fail to learn from history are doomed to repeat it,” and as recent events have demonstrated, many European banks held too little loss-absorbing capital to allow for the risks being run not only in extreme adverse conditions, but in some of the more vanilla activities, as well. The Irish mortgage market is a prime example – with no one expecting the long tail event of corrections in residential property valuations, which has left many builders and homeowners with assets that are worth significantly less than the valuations provided for mortgages to be granted over them.

To prevent a repeat of the recent scenario, Basel III emerged as a proposed revision to Basel II in 2009, and was published as a new framework on December 16, 2010. Since then, regulators both in Europe and around the world have been tackling the hard questions regarding the various types and standards of capital required under Basel III, seeking, in some cases, to amend current provisions under Basel II, rather than replace them outright.

The results of the latest European Banking Authority (EBA) stress tests, announced just last month, make it clear that some banks in Europe will remain undercapitalized for the loss absorption required during periods of stress.

As the EBA results showed, there were eight banks that failed the requirement under stress scenarios to maintain a floor value of 4 percent Tier 1 capital. A deeper look reveals a more complex situation. Basel III requires that banks hold a minimum of 7 percent Tier 1 capital, taking into account both minimum capital requirements and a capital conservation buffer. And, this is before additional capital requirements for systemically important financial institutions are imposed, or national regulatory discretions exist where, for example, the Financial Services Authority (FSA) might require banks to hold additional capital depending on the types of business that they are supporting.

Taking this into account, banks that fail the test are not eight out of 90 (about 9 percent), but 41 out of 90 (accounting for 46 percent), eliciting a different level of concern and confidence.

The European Commission, by contrast, unveiled a proposal on July 21, 2011, which would harmonize capital requirements at 7 percent for lenders throughout the single market consisting of 21 nation states. Thus, regardless of the type of lending performed by a bank within the European Union – from lending solely to AAA-rated sovereigns such as Germany or France to lending on sub-prime mortgages – the capital requirement would be 7 percent.

The Commissions’ proposition is justified in such a way that, by creating a level playing field, no one member state can obtain advantage over another by specifying a lower floor for Tier 1 capital requirements, which could create an environment restrictive of risky behavior in certain states of the European Union.

While this argument is sound in and of itself, this is an argument for a minimum standard, not an upper limit. If the recent financial crisis tells us anything, it is that maintaining a floor value of loss absorbent capital in times of stress ensures soundness in a financial system. In contrast, by creating a minimum requirement no one state obtains advantage over the other – by setting a standard, this reduces the opportunities for innovation or creativity in financial products, and can, in turn, reduce shareholder value.

Moreover, the nature of European banking operates against an approach that would suggest that all are of the same size and thus can be treated in the same way. Not only do different member states’ banking sectors operate differently, they lend to different consumer and corporate objectives. As important, the capacity of individual member states to stand behind their banks is different.

The European Commission’s latest proposal creates an even more challenging environment for financial services organizations that are seeking to define a path forward in terms of their risk management strategies. It underscores, once again, the need for unprecedented agility and, more important, visibility into the overall soundness of their organization under various scenarios.

Irrespective of which approach is taken by the legislators in Europe, it is now more important than ever that IT infrastructure is in place to ensure that a full view of the asset and liability position of banks and financial institutions (including, let’s not forget, insurers) can be taken on an intraday basis.

This blog was contributed by John Christiansen, a senior director of sales consulting for Oracle Financial Services Analytical Applications.