The Surge in Shares of Major Banks Indicates the Strength of EU Financial Regulation

Critics refer to the agreement in Basel on the new EU financial regulation as a ‘lukewarm compromise’. The main agenda item, the ratio of so-called Tier 1 capital to risks, has been raised from the previously symbolic two percent to a colossal seven. However, this will only take full effect in 2019, with the introduction beginning in two years.

written by Vanja Figenwald
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Although it began to seem that bankers would manage to avoid the regulatory hammer, recent weeks suggest the opposite conclusion. The diligent members of the Basel Committee on Banking Supervision, brought together from 27 countries, turned a new page in the book of the financial industry on Sunday, September 12. On that day, a so-called historic agreement was reached on how to curb bankers’ appetites and limit losses in bad cycles, named Basel III. Market reactions, however, clearly indicated that the rules are not as frightening as feared, which is a repeat of every major regulatory decision in that industry. Shares of the best-capitalized banks like JP Morgan and Société Générale surged by 4.3 and 3.4 percent, respectively, signaling market satisfaction with the achieved compromise.

The main agenda item, visibly trimmed to a topic on which some sort of agreement could be reached, was the ratio of so-called Tier 1 capital, raised from the previously symbolic two percent to a colossal seven, although it was expected that this figure would be six percent. This refers to the ratio of core capital to risk-weighted assets, or the bank’s placements (the most valuable assets put in ratio with future losses), and it should be added that a very important caveat was raised even around such a compromise decision. The rules will only take full effect in 2019, with the introduction beginning in two years, precisely to prevent a third crisis in this decade. Such a generous adjustment period is justified by the need to limit banks’ wide maneuvering space, but not so much that it simultaneously jeopardizes the fragile recovery of the economy, largely dependent on the goodwill of banks, an argument that bankers and lobbying groups have squeezed the soul out of in recent months.

Limited Bonuses
The new core ratio has been raised from 2 to 4.5 percent with a so-called buffer zone of an additional 2.5 percent, so banks whose ratio falls into the specified buffer zone will face restrictions on dividend and bonus payments. This percentage will likely be increased by 2.5 percent at the peaks of the economic cycle because the previous Basel II was extremely pro-cyclical, but the details of that rule remain undeveloped for now. The President of the European Central Bank, known for his directness, Jean-Claude Trichet, made a rather atypical formal statement after the agreement, calling it a ‘fundamental strengthening of global capital standards’, adding that ‘the contribution to long-term financial stability and growth will be significant’.

This diluted agreement is the result of a very concrete need to gain the consent of Germany, a country that was portrayed in the media in the days just before the final agreement as the main opponent of the sudden calming of agitated banks. The reason for the stubborn German opposition was their public banks, which will need quite a bit of additional capital to achieve the agreed percentage. Critics have claimed that delaying new liquidity standards, the second measure under development, until 2015 can only jeopardize the financial system, adding that they doubt the agreed percentage as a guarantee of some sort of security, which, after all, seems quite logical since seven percent of total placements in a crisis moment like the one that has just occurred, in which all placements seem shaky, does not seem particularly reassuring. On the other hand, many warn of the principled nature of the agreement and the fact that Basel III will likely be strengthened or accelerated in practice for some countries. For example, in the United Kingdom, stronger regulation of fees in the sector is expected, and in the U.S., Congress could force regulators to adopt shorter timelines and stricter rules.

For a Better Time
Another topic left for a better time, new liquidity standards, fuels the critics’ mill convinced that the agreement is a lukewarm compromise in the interest of the financial industry. Bankers and corporate borrowers have also breathed a sigh of relief regarding this after it was decided that the aforementioned rules would be placed in ‘observational’ status (markets will be carefully studied to assess the functionality of the ratio) until 2015 due to fears that determining a concrete number for the first time in history could have unforeseen effects on lending. The ‘liquidity coverage ratio’ under which banks would have to hold reserves equal to 100 percent of undrawn corporate credit lines has raised fears that the price of commercial paper and working capital could rise significantly.

The next measures under the liquidity rules that the Basel Committee is toying with relate to reducing banks’ dependence on short-term financing, on hold until 2018, and an additional set of rules for large global banks that the Committee deems important for the system. The Germans can thus be definitively the most satisfied with what has been achieved, as is clearly seen from the statement of their central bank governor Axel Weber, who stated that ‘German banks were treated with exceptional consideration’. According to estimates, most European and American banks will be able to meet the new criteria without major problems, so it is clear that after this agreement, everyone is happy, which does not actually fill the taxpayer, a generous financier of banking failures in recent years, with excessive security.

If banks are happy, experience has shown, the taxpayer could soon be very unhappy. Another consequence of the new standards is the further stratification of large and small banks because, quite obviously, large banks will find it easier to access new capital compared to smaller banks, which could struggle further with this. Americans and the British have also remained dissatisfied, having long been eager for banking blood and openly interested in much stricter criteria. However, since these are frameworks, it can be expected that countries from their camp will introduce versions of the agreed in regulatory practice with a few additions. The final outcome is in line with the trend, a compromise that has faced many criticisms and left many not overly convinced of its effectiveness.