Home The C-SuiteChief Compliance Officer (CCO) Why Are Americans and Europeans Fighting about Banking Regulation?

Why Are Americans and Europeans Fighting about Banking Regulation?

by internationaldirector

Written By: David Winter – Corporate Finance

Central bankers from around the world, who met recently in Sweden to discuss the reform of solvency ratios, did not come to an agreement. Behind a highly technical debate is the opposition of two different approaches on risk management, hiding also an economic war between Europeans and Americans. After the June Basel Committee on Banking Supervision (BCBS) meeting took place in Sweden, European banks can be relieved…at least for a few months. The two-day meeting of the Banking Supervision committee ended without publication of a final communiqué, noting the lack of agreement in silence. The next meeting will take place in September in Switzerland. The stakes for European banks are huge.

This international committee, which brings together the central banks and financial authorities of some 30 countries, has been debating for months the reform of the global rules of solvency of banks (decided after the bankruptcy of Lehman Brothers and the global financial crisis).

The war of risk-assessment methods.

To determine the level of capital that a bank needs to avoid collapsing because of defaulting counterparts, banks have to assess the level of risk on their assets (loans) and weigh the amount lent with this risk level. Then they must allocate capital in proportion to those risk-weighted assets to stay on the safe side.

Methodologies of risk assessment have changed since the crisis:

  • On the one hand, there is the standard method—first historically introduced and still applied in the United States—that consists of assigning the same probability of default to each asset class, without nuance (states assessed at 0 percent risk, 50 percent for real-estate loans, 100 percent for business loans).
  • On the other hand, internal rating systems (Basel II) are applied by European banks, based on the banks’ own data. Those systems allow risk to be weighted according to the probability of default and loss in case of default for each and every counterpart. This method also allows decreasing risk by taking into account the guarantees specific to each counterpart.

The second approach is for sure more complex, involving collecting numerous data as well as performing detailed calculations and analyses. Its implementation has cost millions for European banks. But, as the system is internal and specific to each bank, it gives some freedom in modelling the risks, and it could be accused of being too subjective.

European regulators are accusing the standard method of lacking precision: how to justify that the same 100-percent risk is allocated to all companies, while some OECD (Organisation for Economic Co-operation and Development) states, although weighted at 0 percent, could prove to be risky?

When looking at the capacity for detecting or preventing default, both methods are subject to criticism:

  • The standard method did not issue an alert from the balance sheets of Lehman Brothers and Co., and there are several hundred bankruptcies in the United States every year.
  • However, the internal models also have their weaknesses and have not allowed proper evaluation of the risk of losses on toxic assets, for instance for Spanish Banco Popular.

Americans are fighting to reduce the gap between the two by introducing a floor: banks using internal models (Basel II) would not be able to fall below 75 percent of the result obtained with the standard method. This would in a way mean that European banks would come back to the standard method, throwing away their past efforts to develop precise internal systems. And American banks would definitely get the advantage. An agreement on the floor of 75 percent was the scenario of catastrophe feared by the European—German, Dutch and French—banks, the latter having expressed their concerns in recent days.

Beyond the methodological war are real financial and economic stakes.

The introduction of a “floor” would likely force European banks to raise money to strengthen their equity. McKinsey, the management consulting firm, has estimated the need for additional capital for all European banks at €120 billion if a 75-percent floor was applied. One could say that European banks indeed need capital strengthening, considering their still existing amounts of nonperforming loans.

But the consequences of increasing capital would be numerous for European banks:

  • less funds available to finance the economy,
  • more capital placed in low-risk assets, with very poor yields (reserves with the European Central Bank are even taxed, the rate being negative 0.4 percent),
  • profitability of bank equity, a key indicator to attract investors, will appear to be decreased.

This US proposition seems dictated by purely economic and competitive purposes.

The US Treasury, headed by a former Goldman Sachs executive Steven Mnuchin who was appointed by President Donald Trump, has just published a 150-page report detailing measures to alleviate regulatory constraints on US banks. In particular, the US Treasury recommends deferring the application of the new liquidity, capital, debt and leverage rules.

“The impact of international standards on the competitiveness of US financial institutions globally demands a thorough review,” the report states bluntly. “International regulatory standards should only be applied taking into account their alignment with national objectives and should be adapted to meet the needs of the financial services sector in the United States.”

No doubt that the war for the leadership of international finance is at stake.


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