US and UK Capital Plans Clash with EU’s Basel III Vision

US and UK regulators have unveiled an emergency cross-border plan aimed at preventing a systemic collapse of the banking system that is at odds with European leaders' plans to water down the amount of capital banks need.

While US and UK lawmakers outline proposals to force shareholders and creditors on both sides of the Atlantic to take losses, their other main focus is that there is enough capital stashed away so that taxpayers are not hit.

However, the Basel Committee on Banking Supervision will be tussling with politicians and regulators over the liquidity coverage ratio (LCR) this week. The LCR is the amount of cash and less risky assets owned by a bank.

In Europe, Basel III commitment rules that the minimum requirement for banks' tier-one capital ratio (ratio of equity capital to risk-weighted assets [RWA]) has been raised from 2 percent to 4.5 percent and is effective as of 2019.

Lenders will also need to add a "conservation buffer" of 2.5 percent, meaning banks must hold a total core capital equal to 7 percent of their RWA.

However, European Central Bank president Mario Draghi and outgoing Bank of England (BoE) governor Sir Mervyn King are just two of the many critics who have said that such stringent capital requirements will choke interbank lending and hurt economic recovery.

This week, Basel Committee chairman and governor of Sweden's Riksbank, Stefan Ingves, who claims there is no hard evidence of such damaging side effects, will be negotiating capital requirement levels with global banking regulators.

The dispute among policymakers is at odds with the US and UK leaders. The BoE's deputy governor Paul Tucker's opinion over liquidity requirements clashes with his boss.

The US' Federal Deposit Insurance Corporation (FDIC) and the BoE issued a joint paper highlighting an emergency action plan for making the biggest banks as solvent and "less risky" as possible.

Tucker and FDIC chairman Martin Gruenberg outlined a US-UK template for their 12 large international banks which will be a template for the 16 systemically important banks (G-Sifis) based in other countries.

"All countries share a very strong public interest in developing the capacity to resolve global systemically important financial institutions in a credible and effective way," said the two bank regulators.

The paper pointed out that under the new plan, shareholders should expect to be wiped out and unsecured bondholders "can expect that their claims would be written down to reflect any losses that shareholders cannot cover" in order to prevent a huge taxpayer-funded bank bailout which has led to the government owning 83 percent of RBS and 42 percent of Lloyds.

However, such plans would mean that capital buffers would also need to be significantly high, in order for these "emergency resolutions" to be implemented. The strategy paper says that US and UK banks do not hold sufficient debt and equity in their group holding structures, signalling capital requirements would be addressed soon.

The Divide

One of the lessons learned from the credit crisis of 2007 is that banks had too many risky assets on their balance sheets and not enough capital was set aside to help stop an industry-wide collapse.

Since then, regulators around the world have created and implemented a raft of regulatory changes whose key focus is on reducing the amount of RWA on banks' balance sheets, more cash set aside at presubscribed level, and implementing stress tests to prevent a repeat of the crisis.

The LCR, which Basel Committee leaders are now trying to defend, is a good example of the difference in opinions over whether such high liquidity requirements may stop economic recovery. That would mean that the measures put in place to prevent a fresh crisis could also slow down efforts to get out of the current crisis.

While it is accepted that higher capital requirements are needed, the stringent level of liquidity buffers in line with Basel III rules and a number of other global regulatory demands will have too much of an impact on recovery.

According to figures published by the Basel Group, a sample of 209 banks assessed by the Basel Committee had a collective shortfall at the end of 2011 of €1.8tn ($2.3tn, £1.4tn) in the assets needed to meet the LCR.