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Making sense of the CRD4/CRR debate

There are two main issues in the CRD4/CRR debate (the acronyms stand for the fourth Capital Requirements Directive and the Capital Requirements Regulation). First, the legislation’s departures from the Basel III Capital Accord; and second, whether individual member states should be allowed to impose core prudential requirements (known as Pillar I) beyond the commonly agreed […]

By: Date: May 2, 2012 Topic: European Macroeconomics & Governance

There are two main issues in the CRD4/CRR debate (the acronyms stand for the fourth Capital Requirements Directive and the Capital Requirements Regulation). First, the legislation’s departures from the Basel III Capital Accord; and second, whether individual member states should be allowed to impose core prudential requirements (known as Pillar I) beyond the commonly agreed minimum, especially as regards capital ratios.

The first item matters not only for the EU but also from a global perspective. The current EU debate is mostly about the definition of capital, and especially the exception for so-called “silent participation” in some German banks and the capital treatment of insurance subsidiaries, which affect some large French banks among others; on both items, the CRD4/CRR draft is seen by many observers as not compliant with Basel III.

I would argue it is part of a broader question. The EU was a strong promoter of internationally consistent financial standards before the crisis. One main reason is that this helped EU institutions fulfill their own agenda of single market harmonization. The EU promotion and adoption of Basel II (the original Capital Requirements Directive), but also its 2002-05 adoption of International Financial Reporting Standards (IFRS) are quintessential examples of this: there was a de facto alignment of interests between EU institutions and global standard-setters, and EU institutions tended to view harmonization as an overriding good that would supersede most misgivings they may have about a particular standard’s content. There were exceptions of course (e.g. the “carving out” by the European Commission of some parts of the IAS 39 accounting standard on financial instruments when it was endorsed into EU legislation in late 2004) but the general picture was very consistent. This made the EU an outlier in the global context, as a consistent champion of global standards even when it did not determine their content (Elliot Posner and I analyzed this dynamic in a 2010 paper).

The crisis has changed that. Now, EU institutions seem to care more about the content of the standards than about global harmonization or convergence per se. This is not necessarily a conscious change: in both the Commission and Parliament, most people still see the EU as an internationalist player. But in practice the EU now looks much more like the US, in favor of global standards when it “likes” them and not in favor when it “dislikes” them. However things are made more complicated in the EU by the fact that there is much less of a consistent infrastructure for policy elaboration to determine whether a standard is “liked” or “disliked”, often resulting in high vulnerability to special-interest pleading. From a global perspective, it is destabilizing for global standard-setters as they have lost the EU as a consistent global champion compared with the previous era. Many EU officials still underestimate the extent to which CRD4/CRR deviations from Basel III undermine the global authority of the Basel Committee. Many other jurisdictions are carefully watching the direction in which this EU legislative debate goes. If the EU adopts final legislation that is not compliant with Basel III in terms of the definition of capital, it will be seen by at least some others as a license to introduce their own deviations that suit their own special interests.

Obviously the US does not help by delaying their own proposals for Basel III implementation. In November 2011, Federal Reserve Board Governor Daniel Tarullo publicly announced there would be a public regulatory proposal before the end of March 2012. We are in early May now, and still waiting. This is a regrettable failure of US leadership. If the US published a proposal that is Basel III-compliant, it would create a strong incentive for the EU to comply as well. The same is true in the IFRS space, where the US Securities and Exchange Commission keeps delaying its stance on IFRS adoption, thus undermining the global credibility of IFRS. Almost everybody accepts that the US is not going to adopt all IFRS in the short term or even set a firm date for complete adoption given domestic political constraints. But the SEC’s “condorsement” concept allows for a lot of flexibility in terms of gradual adoption. That the SEC remains so far unable to commit itself to even a minimalist form of IFRS condorsement is disheartening from the standpoint of global financial reform.

The second big issue in the CRD4/CRR debate is arguably more of an intra-EU matter. The European Commission argues in favor of a “maximum harmonization” approach that prevents individual member states from raising their Pillar I capital requirements from the commonly agreed minimum, on the basis that this would introduce competitive distortions inside the EU single market. But this argument seems to ignore that the main distortion by far in the EU market for banking services is the fact that most of the bank supervision /resolution policy framework remains national, which pegs banks’ financial situation to the situation of their home-country sovereign, with disastrous effects these days particularly in the Eurozone. The Commission’s DG MARKT has failed to properly address this distortion: a legislative proposal on bank crisis management and resolution, which is not even published in draft form at this point, should have come much more forcefully and earlier, arguably as early as mid-2009 to preempt diverging legislative moves on national resolution frameworks which have been adopted by many member states in the meantime.

Given this failure, the Commission’s argument that higher capital requirements in countries such as Sweden or the UK would harm the single market rings somewhat hollow, especially as the Basel Committee has been explicit on the fact that its standards were a mere minimum and that individual jurisdictions were encouraged to go beyond, as Switzerland in particular has already decided to do. In its comment letter on the CRD4/CRR proposals in March, the European Systemic Risk Board has come up with a balanced proposal to combine freedom to decide on macro-prudential measures in individual member states, including by raising Pillar I capital requirements, with the need for EU-level coordination. These proposals make a lot of sense and should be endorsed in the final legislation.


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