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Banking Supervision: reform of the capital adequacy framework frequently asked questions

Commission Européenne - MEMO/01/15   23/01/2001

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MEMO/01/15

Brussels, 23 January 2001

Banking Supervision: reform of the capital adequacy framework frequently asked questions

What is the EU capital framework?

The EU capital framework, i.e. the amount of capital which supervisors require financial institutions to hold in order to cover adequately the risks to which they are exposed, is currently based on the 1988 Basel Accord and its amendments. The Basel Accord was agreed by the G-10 banking supervisors in the Committee on Banking Supervision of the Bank of International Settlements (known as the Basel Committee). The Committee comprises Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland, United Kingdom, United States. The European Commission participates as an observer.

Why does it need to be revised?

An international consensus now exists that capital charges for credit risk (by far the greatest element in banks' business) need to be revisited. It was recognised that regulations were increasingly failing to capture the risks that banks and investment firms are undertaking and also that the current regime was failing to deliver adequate incentives for prudent risk management. At worst, the present regime is leading to misallocation of resources and regulatory capital arbitrage opportunities (ie opportunities for evading the charges) and lacked the flexibility to adapt to innovation. Revision of the EU framework is a key objective of the Financial Services Action Plan to achieve by 2005 a fully-integrated market in financial services (see IP/00/1269).

What will the revision achieve?

The aim is to deliver a refined risk based focus for capital allocation requirements (other than market risk) while maintaining minimum levels of capitalisation and continuing to promote competitive equality. The starting point is a revision of the treatment of credit risk (ie. Bank lending to customers). Beyond this, the revision will consider the introduction of new risk categories (risks other than credit risk, eg. reputational risk of a bank ). The review also endorses a more developed emphasis on the rule of the supervisor in reviewing institutions' capital strategies and puts forward proposals relating to disclosure and transparency by institutions as an aid to market discipline.

What is the relationship between the EU and Basel?

Eight EU Member States sit on the Basel Committee (see above) and Spain will join in February. This overlap means that the EU needs to maintain and be part of creating global best practice standards for prudential soundness as well as ensuring that there is an international level playing field for our institutions.

The Commission, as observer, can ensure that non-Basel EU states are fully informed of developments and ensure that, to the extent possible, EU Member States in Basel act in the collective interest. It represents the views of the EU as a whole and working with the support and co-operation of national experts from the Member States has also helped do much of the technical groundwork to test and develop the Basel ideas in an EU context.

So are the review processes the same?

No, they are overlapping (our legislation is already based on the 1988 Accord and the 1996 Market Risk Amendment) but not identical. The EU process is legislative, the Basel process is not. The EU framework applies to all banks and investment firms and is thus wider in scope than Basel because we linked the capital framework for banks and investment risk in the Capital Adequacy Directive for market risk (1993/6/EEC) because of the need to ensure a level playing field between two sectors who compete directly. The Commission is, however, along with the industry and Member States, committed to ensuring the EU regime will be complementary and not contradictory with the Basel approach. Any differences are likely to be in the emphasis and fine-tuning the revised EU framework will need to take proper account of the full range (in terms of scale and sophistication) of the EU industry.

Why does there need to be a second consultation?

Now that the technical details are more refined we have to ensure that our approach takes full account of the EU context. For example, we may need to introduce some more refinements, particularly for investment firms. The paper, due for publication at the end of January or beginning of February, will clarify the relationship between the two processes it is designed to be read in conjunction with Basel. We are not "inflicting" another 500 page document on industry.

What is the Commission intending to propose?

The intention is that the new EU capital framework, like the new Basel Accord, addresses the revision of the treatment of credit risk (including credit risk mitigation), operational risk, supervisory review process and market discipline. Some adjustment to the treatment of consolidation is also included. The technical details will be released when we publish our second consultation.

Given that there are so many smaller scale institutions in the EU, isn't this revision over-complex?

No, it is the old "one-size fits all" approach that no longer works. We are trying to create a framework that recognises the diversity of the European scene, that spans global players as well as locally-active firms or those with a restricted scale of business It is certainly not our intention to introduce a complex and burdensome raft of new measures. As for small and medium-sized business that are so dependent on access to finance and vulnerable to the cost of funds, we believe the new approach has the scope to improve treatment of this sector, such as recognition of a number of risk mitigation practices common in this sector.

What happens now?

The Basel Committee has published its second consultation (see the BIS website on http://www.bis.org) and asked for comments by 31 May. We will publish our second consultation paper around the end of January or beginning of February, asking for comments by the same deadline. The information we gather will influence the final shape of our new legislative proposals to be published in autumn, around the time the Basel Committee will publish its final accord. The Commission's legislative proposals will of course need the approval of Member States and the European Parliament. The Financial Services Action Plan foresees that the new rules be implemented by 2004, in line with the new Basel accord.


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