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Implementing Basel III A Comparison of the EU and U.S.

Introduction:

The Basel III accords finalized in December 2010 set out a new international framework for

banking regulation. The financial crisis underscored the weaknesses in the previous regulatory

regime and served as a catalyst for regulators to agree on heightened standards that would

strengthen the resiliency of the banking sector in the case of future shocks stemming from

financial or economic stress.1 In the years since, the European Union (“EU”) and the United

States (“U.S.”) have implemented Basel III recommendations to varying degrees, with both

jurisdictions enacting legislative changes to banking and financial market regulation.2

This paper analyzes the approaches to implementation in the EU within the context of the post-

crisis regulatory structure. In doing so, the paper begins with an overview of the major

recommendations made by Basel III and their rationales. The paper then compares European

efforts towards instituting the Basel III recommendations to the process of Basel III

implementation in the United States. Finally, the paper provides an examination of the reasons

for possible divergence between European and American implementation progress and offers an

analysis of the differences in financial market and regulatory structures in the two jurisdictions.

1 Basel Committee on Banking Supervision (“BCBS”), “Basel III: A global regulatory framework for more resilient

banks and banking systems”, December 2010 (rev June 2011). 2 In the US, the Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) was passed before Basel III

accords were finalized, but many of the provisions in Dodd-Frank give prudential regulators the ability to craft rules

in line with Basel III recommendations.

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Understanding Basel III:

Basel III is the third attempt at creating a global regulatory framework that would minimize

opportunities for internationally-active banks to benefit from regulatory arbitrage.3 The first

attempt in 1988 aimed at making regulation of bank capital consistent across jurisdictions, but

was criticized for being too simple and, as a result, encouraging banks to make riskier loans and

hold riskier securities. Basel II, introduced in 2004, tried to correct this problem by introducing

risk-weighted assets for measuring capital adequacy. The idea was that by assigning different

capital requirements to different assets based on their relative risk, banks would be less likely to

make balance-sheet decisions based on the regulatory capital treatment of certain assets and

instead would make lending choices based on traditional factors like credit and market risk.

However, the financial crisis exposed serious failings in this methodology as risk models that

determined the appropriate risk-weight for different assets proved deeply flawed, and bank

capital proved inadequate in withstanding the financial and economic stresses stemming from the

U.S. subprime housing market collapse.

The Basel committee identifies excessive on-and-off balance sheet leverage, an erosion of the

level and quality of capital, and insufficient liquidity buffers as the primary reasons that the

economic and financial crisis in 2007 became so severe.4 Basel III addresses these flaws by

raising capital requirements and expectations for liquidity and risk management standards.5 The

new capital standards are guided by three pillars: First, increasing the quality and quantity of

3 Regulatory arbitrage refers to banks moving operations and lending activities to different jurisdictions to profit

from more favorable capital requirements. For more on this, see Joel F. Houston, Chen Li, and Yue Ma, “Regulatory

Arbitrage and International Bank Flows.” August 26, 2011. 4 BCBS, Basel III: A global regulatory framework for more resilient banks and banking systems, p.1 5 See Figure 1 in the Appendix, which charts the evolution of the Basel accords from 1988 to the present.

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capital held by banks; second, improving risk management and supervision at banks; and third,

enhancing market discipline by increasing transparency.6

Pillar I: Increased Capital

Inadequate loss-absorbing capital heightened market uncertainty during the financial crisis and

necessitated costly taxpayer bailouts of a number of major financial institutions. Basel III

addresses this deficiency by raising requirements for both the level and quality of capital held by

banks. The new rules raise minimum total capital levels to 8 percent of risk-weighted assets and

minimum common equity tier 1 (CET1) capital to 4.5 percent.7 By emphasizing common equity

as a primary source of capital and narrowing the types of loss-absorbing instruments that may

count as capital, Basel III attempts to ensure that regulatory capital truly is reliable as a buffer

against losses.8 Basel III also introduces a capital conservation buffer that empowers regulators

to address capital deficiencies by restricting dividend and bonus payments, and a countercyclical

buffer determined by regulators that can force banks to increase capital levels above minimums

prescribed in Basel III when they perceive risks to financial stability are growing.9 Finally, Basel

III introduces a leverage ratio that complements the traditional risk-based capital approach.10 The

leverage ratio, which measures capital by dividing the tier 1 capital (primarily equity) according

to the risk-based capital framework by an exposure measure that includes both on-and-off

balance sheet exposures, is introduced as a mechanism for limiting the potential for banks to

“game” the risk-based capital framework as, unlike this framework, the leverage ratio treats all

6 See Figure 2 in the Appendix, which provides an overview of the three pillars and their objectives. 7 BCBS, Basel III: A global regulatory framework for more resilient banks and banking systems, p.12 8 The new rules define Common Equity as the sum of common shares issued by the bank that meet regulatory

criteria for classification as common shares, and retained earnings. See, BCBS, Basel III: A global regulatory

framework for more resilient banks and banking systems, p.13 9 Eric Chouinard and Graydon Paulin, “Making Banks Safer: Implementing Basel III” in Bank of Canada, Financial

System Review, p.53. June 2014 10 BCBS, “Basel III leverage ratio framework and disclosure requirements” January 2014. p.2

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assets as equally risky.11 While it may be possible to fool one of these frameworks for measuring

capital, because these frameworks give opposite incentives to banks seeking to minimize their

regulatory capital requirements, it is exceedingly difficult to fool both simultaneously.12 Indeed,

many banks have complained that the capital level required under the new leverage ratio has

replaced the risk-based capital framework as the effective regulatory minimum standard for

capital requirements.

Adjustments to the capital framework also include enhancements to risk coverage to ensure “that

all material risks are captured in the capital framework.” The rationale for these enhancements

comes from the fact that the failure of the previous capital framework to adequately capture off-

balance-sheet risks and derivatives exposures amplified the crisis.13 For example, inadequately

accounting for counterparty credit risk where certain counterparty exposures were significant

made it difficult for regulators and market participants to assess the adequacy of capital levels at

banks during the crisis. As a result, Basel III proposes a revised metric for addressing

counterparty credit risk, credit valuation adjustments, and wrong-way risk.14 These changes are

designed to ensure that risk models used in calculating capital requirements are sufficiently

considering risks that are amplified in periods of market stress even if they are insignificant in

“normal” times.

11 During the crisis, many banks increased their leverage by moving assets off their balance sheet through the

creation of special investment vehicles, but retained the credit risk associated with those assets because they

guaranteed the commercial paper issued by these companies against losses. In effect, though their economic

exposure was unchanged, banks were required to hold less capital against these assets. 12 Dan Davies, “Facts and Myths about Bank Leverage Ratios”, October 28, 2014. 13 BCBS, Basel III: A global regulatory framework for more resilient banks and banking systems, p.29 14 Ibid, p.30

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Capital Surcharges for Global Systemically Important Banks

In addition to the changes to the Basel capital framework outlined above, Basel III provides for

the introduction of more stringent capital requirements for banks identified as systemically

important. The financial crisis demonstrated that failure or impairment of a large, global

financial institution could destabilize the financial system and lead to increased stress on other

institutions, even across jurisdictions. In its attempt to address this problem, Basel III presents a

framework for identifying and increasing resiliency of Global Systemically Important Banks

(“G-SIBs”).15 The framework takes a multi-pronged approach aimed at reducing the “probability

of failure of G-SIBs by increasing their going-concern loss absorbency and reducing the extent

or impact of failure of G-SIBs by improving global recovery and resolution frameworks.”16 The

framework uses an indicator-based measurement approach to identifying G-SIBs. These

indicators are based on the different characteristics that contribute to negative externalities and

make certain banks critical for financial stability.17 Based on a composite score of the five main

indicators (Cross-jurisdictional activity, size, interconnectedness, substitutability, and

complexity), the framework places banks into a bucket that assigns an additional capital

surcharge between 1 and 3.5 percent of risk-weighted assets.18 A breakdown of the methodology

for determining systemic importance and the various buckets for assigning capital surcharges is

available in Figure 3 at the end of this paper.

Pillar II: Enhanced Supervision

In addition to the quantitative adjustments to required capital levels and the narrowing of the

instruments that count towards a bank’s capital, Basel III also lays out a framework for

15 BCBS, “Global systemically important banks: assessment methodology and the additional loss absorbency

requirement”, July 2011. 16 Ibid, p. 2 17 Ibid, p.3 18 Ibid, p.4

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heightened supervisory standards. Banking is inherently risky,19 and so a key principle of bank

regulation is that management and the Board must play an active role in monitoring risk and

determining how much risk they are comfortable allowing the bank to take on. In formulating

Pillar II, the Basel Committee on Banking Supervision outlined four basic principles:20

1. Banks should have a process for assessing their overall capital adequacy in relation to

their risk profile and a strategy for maintaining their capital levels.

2. Supervisors should review and evaluate banks’ internal capital adequacy assessments and

strategies, as well as their ability to monitor and ensure their compliance with regulatory

capital ratios. Supervisors should take appropriate regulatory action if they are not

satisfied with the result of this process.

3. Supervisors should expect banks to operate above the minimum regulatory capital ratios

and should have the ability to require banks to hold capital in excess of the minimum.

4. Supervisors should seek to intervene at an early stage to prevent capital from falling

below the minimum levels required to support the risk characteristics of a particular bank

and should require rapid remedial action if capital is not maintained or restored.

Basel III emphasizes the importance of addressing “firm-wide governance and risk management;

capturing the risk of off-balance sheet exposures and securitization activities; managing risk

concentrations; providing incentives for banks to better manage risk and returns over the long-

term; sound compensation practices; valuation practices; stress testing; accounting standards for

financial instruments; corporate governance; and supervisory colleges.”21 Since the crisis,

different jurisdictions have applied these principles in different ways, but regulatory expectations

for risk management and capital planning at banks has certainly increased. While the details of

how these principles are applied in the U.S. and EU context will be analyzed later in this paper,

19 Richard Apostolik, Christopher Donohue, and Peter Went. Foundations of Banking Risk, John Wiley and Sons,

Hoboken, New Jersey, 2009, Chapter 1, pages 1-21 20 BCBS, “Pillar 2 (Supervisory Review Process)”, pp. 1-2 21 See Figure 2, Bank for International Settlements, Basel III Summary Table

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one important development in both jurisdictions is the increased use of stress tests as a

supervisory tool in determining possible capital restrictions.22

Pillar III: Enhanced Transparency

A principle of banking regulation rooted in a belief in the efficiency of markets is that disclosure

and transparency create incentives for banks to be well-managed and intelligent risk-takers.

Basel III creates new disclosure rules aimed at promoting market discipline, which supplements

the supervisory role played by banking regulators.23 As part of these new disclosure

requirements, banks are expected to explain their approach to measuring risk-weighted assets

and capital for the risk-based capital framework.24 Basel III’s disclosure requirements are based

on the following five principles:25

1. Disclosures should be clear

2. Disclosures should be comprehensive

3. Disclosures should be meaningful to users

4. Disclosures should be consistent over time

5. Disclosures should be comparable across banks

By increasing transparency, Basel III aims to improve market confidence in the adequacy of

capital levels at banks and prevent a credit crunch similar to the one experienced following the

failure of Lehman Brothers in 2008. If investors and creditors can effectively assess and compare

the capital levels across banks, they will more accurately be able to determine relative risk levels

at different banks. This also has the added benefit of incentivizing banks to compete with one

22 In the US, stress tests are conducted annually by the Federal Reserve System; In the EU, the EBA and ECB have

recently conducted independent stress tests as part of their supervisory activities 23 BCBS, “Standards: Revised Pillar 3 disclosure requirements”, January 2015. 24 For an example of what these disclosures look like in practice, see The Goldman Sachs Group, Inc. “Regulatory

Capital Disclosures for the period ending March 31, 2014.” 25 BCBS, “Standards: Revised Pillar 3 disclosure requirements”, pp. 3-4

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another in improving the quality of their capital and internal risk models used for capital

planning.

Enhancements to Liquidity Risk Management and New Liquidity Rules

Basel III establishes the first international standards for bank liquidity and funding.26 The

financial crisis exposed severe shortcomings in the liquidity planning frameworks at banks,

which often relied on short-term, runnable wholesale funding. This left many banks –

particularly those without a deposit base (e.g. Lehman Brothers) – exposed to swift changes in

market sentiment regarding their viability, causing a loss of funding and, subsequently, forced

asset sales with negative effects for other financial institutions.27 To reduce the likelihood of

similar funding emergencies and resulting fire sales, Basel III introduces the Liquidity Coverage

Ratio (LCR) and the Net Stable Funding Ratio (NSFR).

The LCR is designed “to promote the short-term resilience of the liquidity risk profile of banks”

by ensuring that banks have an adequate stock of high-quality liquid assets (HQLA) that can be

converted easily into cash to meet liquidity needs under a 30-day stress scenario.28 Basel III

defines the LCR as the stock of unencumbered HQLA divided by net cash outflow over a 30-day

stress period.29 To satisfy this requirement, banks must maintain an LCR greater than 100

percent, ensuring that they are never in a situation where they are forced to sell assets at a steep

discount in order to secure funding.

Similarly, the NSFR is designed to reduce what regulators identified as an overreliance on

wholesale funding markets by requiring banks to secure sources of stable, long-term funding

26 Chouinard and Paulin, “Making Banks Safer: Implementing Basel III”, p.54. 27 BCBS, “Sound Principles for Liquidity Risk Management”, pp.1-2. September 2008. 28 BCBS, “Basel III The Liquidity Coverage Ratio and liquidity risk monitoring tools”, January 2013. 29 Ibid, pp. 6-7

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relative to the composition of their assets and off-balance sheet activities.30 The NSFR is defined

as available stable funding divided by required stable funding and, like the LCR, must be above

100 percent to satisfy Basel III requirements. Basel III defines these two inputs as follows:31

“Available stable funding is defined as the portion of capital and liabilities expected to be reliable

over the time horizon considered by the NSFR, which extends to one year. The amount of such

stable funding required ("Required stable funding") of a specific institution is a function of the

liquidity characteristics and residual maturities of the various assets held by that institution as

well as those of its off-balance sheet (OBS) exposures.”

Both of these measures are designed to re-emphasize the importance of sound liquidity

management after a movement towards an exclusive focus on bank capital in the international

regulatory framework. The crisis demonstrated that even well-capitalized banks experienced

liquidity problems due to an over-reliance on volatile funding sources and a lack of strategic

planning for securing funding when those funding sources dried up.

Final Thoughts on Basel III

The result of the Basel III recommendations outlined above is a significant attempt by

international regulators at addressing the sources of systemic risk made evident by the financial

crisis. However, the new regulatory framework created by Basel III is not legally enforceable

and must be adopted by national regulators with jurisdiction over banks. Although Basel III

provides a timeline by which it expects different rules to be fully operational, regulators have not

adopted these rules in a uniform way.32 The rest of the paper is devoted to analyzing the process

of implementation in two key jurisdictions, the EU and the U.S., with the goal of explaining the

regulatory divergence between these two major banking areas.

30 BCBS, “Basel III: the net stable funding ratio”, October 2014 31 BCBS, “Basel III: the net stable funding ratio”, p.2 32 See Figure 4 Bank for International Settlements, “Basel III phase-in arrangements”

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Basel III in Europe: Financial Reform and Regulatory Convergence

The European approach to implementing Basel III is characterized by the EU’s efforts to ensure

regulatory harmonization across member states, even at the expense of strict consistency with the

Basel III framework.33 While previous EU implementations of Basel frameworks required

individual member states to adopt laws and regulations in line with Basel recommendations, the

Capital Requirements Regulation (“CRR”) directly imposes a set of uniform standards on all

banks operating in the EU without requiring national governments to transpose these rules.34 The

Capital Requirements Directive (“CRD IV”) similarly forms the basis for supervision of credit

institutions, investment firms, and other financial sector entities carried out under the Single

Supervisory Framework.35 These legal acts demonstrate the significant energy devoted to

achieving regulatory convergence within the European financial system, and explain to some

degree the EU’s willingness to make concessionary exceptions to the strict implementation of

Basel III.36

Lessons from the Financial Crisis for the European Approach to Financial Regulation

The sub-prime meltdown and subsequent sovereign debt crisis in the Eurozone revealed

significant vulnerabilities in the structure of the European financial system. Although Eurozone

members shared a currency, its banking system remained highly fragmented.37 As a result,

European banks demonstrated a strong “home bias” in the composition of their balance sheets. In

the early years after the adoption of the Euro this did not create significant problems, as

33 Donato Masciandaro, Maria J. Nieto, and Marc Quintyn, “Will they Sing the Same Tune? Measuring

Convergence in the new European System of Financial Supervisors”, IMF Working Paper, July 2009. 34 BCBS, “Regulatory Consistency Assessment Program – Assessment of Basel III Regulations – European Union”,

December 2014 35 European Banking Authority, “The Implementation of Basel III in Europe: CRD IV Package” accessed 5/1/2015 36 Ibid, p.4 – Basel Committee’s RCAP deemed the EU to be “materially non-compliant” with the Basel framework. 37 International Monetary Fund, “European Union: Publication of Financial Sector Assessment Program

Documentation—Technical Note on Financial Integration and Fragmentation in the European Union”, March 2013

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sovereign spreads between different members of the Eurozone were very small.38 However, after

the near-failure of Bear Stearns in 2008, financial market participants began to reevaluate their

assumption that sovereign risk differences between Eurozone members were inconsequential,

leading to significant variation in spreads on European sovereign debt. Consequently, the value

of sovereign debt held by European financial institutions began to diverge, weakening the capital

position of banks in weaker member states with further negative implications for sovereign

risk.39 The experience of the series of banking and sovereign crises that followed made breaking

the “diabolic loop” between banks and their national sovereigns an essential element of post-

crisis reforms.40

The Eurozone crisis also exposed the European approach to regulation as a failure. Without a

banking union, individual Eurozone states were responsible for deposit insurance coverage,

supervision, resolution regimes and, most consequentially, bailouts of failing financial

institutions.41 While this wouldn’t be a problem in countries where the banking sector represents

a small portion of economic activity, smaller states with sizable banking sectors relative to GDP

(e.g. Ireland, Iceland) are significantly at risk when forced to stand behind assets held by national

banks to prevent a bank run. The bailout of Anglo Irish Bank and Allied Irish Bank cost the Irish

government over 60 billion euros, plunging its government into a debt spiral that eventually

necessitated a bailout from international lenders.42 Indeed, the crisis revealed a fundamental

38 Ashoka Mody and Damiano Sandri, “The Eurozone Crisis: How Banks and Sovereigns Came to Be Joined at the

Hip”, IMF Working Paper No.11/269, 2011. p. 4 – See Figure 5 39 The increased probability of a bank failure leads to the recognition of contingent government liabilities resulting

from a possible bailout for its national banking sector. See, for example, the case of the Irish government in 2009. 40 Philip R. Lane, “The European Sovereign Debt Crisis”, in Journal of Economic Perspectives—Volume 26,

Number 3—Summer 2012—pp. 49–68 41 Jeffrey Atik, “EU Implementation of Basel III in the Shadow of Euro Crisis” in Review of Banking & Financial

Law, Volume 33, pp.287-345. p.334 42 Vincent Boland, “Report highlights cost of Irish bank bailout” in Financial Times, March 20, 2014.

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disconnect in a Europe that encouraged cross-border investment through the adoption of a single

currency while maintaining an unequal division of responsibility for managing bank failures. In

theory, the size of contingent liabilities resulting from a bank’s failure would lead a state to

monitor the banking sector closely. Instead, because national banks were major buyers of

government debt and major employers in some countries, authorities operated with a “light-

touch” approach, focusing supervisory reviews on processes and principles while deferring to

internal risk models used by banks.43 The crisis has significantly shifted regulatory attitudes.

The EU Legislative Process: Adopting Basel III in Europe

In the wake of the 2007 to 2008 financial crisis, the EU was an enthusiastic supporter of

developing the new international framework for banking regulation under Basel III. Indeed,

Europe had adopted the reforms under the previous Basel accord quickly and without significant

alterations to the texts issued by the Basel Committee.44 However, the process of developing

legislation to give Basel III legal authority in the EU has proven much more difficult. In part, this

is a result of the European sovereign debt crisis, which happened while negotiations over CRD

IV were ongoing. As Jeffrey Atik puts it, “It is the Euro crisis, and not the fading 2007/2008

financial meltdown, that dominated the mind of the EU legislator during most of the CRD IV

legislative process.”45 But more importantly, the shift away from straightforward adoption of

Basel recommendations reflects the maturation of EU institutions in their role as coordinating

bodies for financial reform and their responsibilities for the integrated supervision of the banking

system.46

43 Klaus Regling and Max Watson, “A Preliminary Report on the Sources of Ireland’s Banking Crisis”, 2010. p.38 44 Frank Dierick, Fatima Pires, Martin Scheicher, and Kai Gereon Spitzer, “The New Basel Capital Framework and

its Implemenation in the European Union”, European Central Bank Paper No.42, December 2005. 45 Jeffrey Atik, 2014. p.290 46 Nicolas Veron, “Europe’s Single Supervisory Mechanism and the Long Journey Towards Banking Union”,

Peterson Institute for International Economics Policy Brief, December 2012.

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Prior to the creation of the Single Supervisory Mechanism and the establishment of the Single

Rulebook, Basel reforms served as an external mechanism to force greater regulatory

convergence within the EU. Indeed, EU institutions gained influence through their role as the de

facto coordinating body for developing EU directives and ensuring these reforms were

transcribed into national laws.47 Thus, implementing Basel reforms aided the EU’s efforts at

improving consistency in European banking law, which the EU believed would help accelerate

financial integration. In the context of the sovereign debt crisis and growing regulatory roles for

European-level institutions such as the ECB and EBA, the EU no longer felt compelled to use

Basel reforms as the sole basis for its financial reform directives. Instead, the EU has adopted an

implementation model which Jeffrey Atik has dubbed “Basel a la carte.”48

The most recent Regulatory Consistency Assessment conducted by the Bank for International

Settlements deemed the EU to be “materially non-compliant” with the minimum standards

prescribed under the Basel III framework.49 This failing grade stemmed from differences

between the risk-weights the EU allows under the Internal Ratings-Based approach for credit risk

and those determined by Basel III, as well as the EU’s interpretation of Basel’s counterparty

credit risk rules.50 Under the CRR, banks have more flexibility in applying a zero risk-weight to

sovereign and other public sector debt, as well to small and medium-sized (“SME”) enterprises.

Additionally, certain derivatives transactions with public sector and non-financial entities are

exempt from the credit valuation adjustment (“CVA”) designed to address risks arising from

over-concentration in exposures to particular counterparties.51 These deviations from Basel

47 Jeffrey Atik, 2014. p.294 48 Ibid, p. 326 49 BCBS, “Assessment of Basel III Regulations: European Union”, December 2014 50 Ibid, p.4 51 Nicolas Veron, “The European Union is the global laggard on Basel III”, December 8, 2014

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standards have a measurable impact on capital calculations and, according to the Bank for

International Settlements, “constitutes an important departure from the letter and the spirit of the

Basel minimum requirements independent of the economic imperatives associated with this

policy choice made under the CRR and CRD IV.”52

Another area of divergence between CRD IV and Basel III is in the treatment of capital for

combined bank and insurance companies. Basel III sought to eliminate opportunities for double-

counting capital towards meeting capital requirements for both banking and insurance

regulators.53 While the EU conceded this during the actual Basel III negotiations, the issue came

up for debate at the European level when it came time to translate these rules into law. Powerful

EU member states including France and Germany, both of which have multiple “bancassurance”

institutions, supported a movement to eliminate the Basel requirement that banks deduct from

what would have been qualifying equity capital any capital serving as reserves for meeting

insurance regulation requirements.54

Controversially, the Basel III minimum standards that the EU has adopted have been converted

into strict rules that do not allow member states to voluntarily institute standards above the Basel

III minimums.55 Three issues were heavily debated in the process of finalizing the CRR and

CRD IV: First, whether member states would be allowed to enact minimum capital ratios above

those specified under Basel III without EU approval; second, whether restrictions on what can be

counted as “high-quality capital” under Basel III should be strictly implemented by EU

legislation; and third, whether the EU should adopt the Basel III deadlines for introducing the

52 BCBS, “Assessment of Basel III Regulations: European Union”, December 2014. p.4 53 Jeffrey Atik, pp. 327-330 54 Ibid, p. 329 55 Ibid, p. 302

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leverage ratio and the new quantitative liquidity requirements (LCR, NSFR).56 Ultimately, the

EU settled on a framework that allowed member states to raise bank capital requirements up to 3

percent above Basel III minimums without EU approval, but significantly widened the types of

instruments that counted as equity capital relative to Basel III standards.57

Concluding Thoughts on the EU Implementation of Basel III

The delayed and diluted implementation of Basel III in Europe is noteworthy for a number of

reasons. First, the EU played a significant role in crafting the Basel III reforms following the

sub-prime crisis in 2007-2008.58 Further, as discussed earlier, the EU has a track record of

relatively timely implementation of Basel recommendations, making its reluctant approach to

instituting Basel III rules notable. In analyzing the EU’s implementation of Basel III, it’s difficult

to ignore the bias towards public sector debt in its bank capital framework, as well as concerns

for the possible impact of higher capital requirements on lending to the real economy. Indeed,

the sovereign debt crisis and subsequent economic recessions in a number of European

economies offers a logical explanation for the apparent willingness to impose less than stringent

capital requirements on bank claims on these favored borrowers. Further, because European

implementation of Basel III involves three levels of politics – global, European, and national –

powerful groups at a number of levels have the capacity to influence the degree to which EU

legislation reflects Basel III recommendations.59

Ultimately, the EU finds itself in a difficult position for implementing Basel III standards. On

one hand, it is seeking to address weaknesses in the financial and regulatory structure exposed by

56 Morris Goldstein, “The EU’s implementation of Basel III: A deeply flawed compromise”, May 27, 2012. 57 Ibid 58 The Basel Committee includes representatives from EU member states Belgium, France, Germany, Italy, and the

United Kingdom in addition to representatives from the EU. Bank for International Settlements, “A Brief History of

the Basel Committee” October 2014. 59 Jeffrey Atik, p. 327

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the crisis and strengthen the credibility of the Single Supervisory Mechanism. On the other hand,

it must work in coordination with EU member states to jump-start economic growth in the

aftermath of the sovereign debt crisis. Due to Europe’s reliance on bank lending as its primary

source of credit, overly-restrictive capital standards could result in decreased financial

integration, further economic stagnation, and increased discontent within EU member states.60

Therefore, it is not surprising that the EU has been slower and more lenient in its implementation

of Basel III than in previous rounds of banking reforms.

Basel III in the United States: Raising the Bar for Financial Regulation

The U.S. has played a leading role in establishing an international post-crisis framework for

regulatory reform in the financial system. Indeed, Former Treasury Secretary Timothy Geithner

has said, “We are committed to building a more level playing field internationally…We don’t

want to see another race to the bottom around the world. As we act to contain risk in the U.S.,

we want to minimize the chances that it simply moves to other markets around the world.”61 As

the global financial crisis originated in the U.S., regulators have focused on enhancing the

resilience of the American financial system to shocks by increasing required capital levels and

improving risk management practices, and have often introduced regulatory minimums above

those required by Basel III.62 This relatively aggressive implementation process in the U.S.

reflects the extensive new mandates for federal regulators created by the Dodd-Frank Wall Street

Reform and Consumer Protection Act of 2010 (“Dodd-Frank”). As a result of these reforms, the

U.S. was judged to be “largely compliant” with Basel III minimum standards.63

60 For an analysis of the effects of the crisis on cross-border bank lending, see Vincent Bouvatier, Anne-Laure

Delatte, “Eurozone bank integration: EU versus non-EU banks”, December 14, 2014. 61 Tim Geithner, “Remarks by Treasury Secretary Tim Geithner to the IMF Conference”, June 6, 2011. 62 For example, the minimum required leverage ratio in the U.S. is 5 percent, compared to 3 percent under Basel III. 63 BCBS, “Assessment of Basel III regulations: United States of America”, December 2014. p.5

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Lessons from the Financial Crisis for the U.S. Approach to Financial Regulation

After the collapse of Lehman Brothers in 2008, the Federal Reserve and Congress were forced

into aggressive fiscal and monetary stimulus. As a result, the U.S. government put in place a new

regulatory framework designed to prevent a similar crisis from occurring in the future. The

fragmented nature of the regulatory system in the U.S. created significant opportunities for

regulatory arbitrage, where financial activities migrated to segments of the financial system

where oversight was lax or non-existent.64 These regulatory failures were at the root of the U.S.

legislative response to the weaknesses in the financial system exposed during the financial crisis.

Dodd-Frank created a committee, the Financial Stability Oversight Council, with the explicit

purpose of identifying and monitoring potential risks to the financial system as a whole and

coordinating effective countermeasures. Dodd-Frank designates all bank holding companies with

more than 50 billion dollars in assets as systemically important financial institutions (SIFIs),

which are to be supervised by the Fed and required to hold more capital than their smaller

competitors. These SIFIs are also faced with “enhanced prudential standards” and are required to

develop credible resolution plans (“living wills”) to allow for their safe liquidation in the event

they become insolvent. 65 In short, the Dodd-Frank Act sought to remedy failures in oversight

and vulnerabilities due to interconnectedness by increasing the authority of regulators and

requiring higher capital ratios.66 These reforms are remarkably similar to Basel III’s emphasis on

raising capital requirements, boosting liquidity oversight, and enhancing supervisory

expectations.

64 Viral Acharya, “The Dodd-Frank Act and Basel III: Intentions, Unintended Consequences, Transition Risk, and

Lessons for Emerging Markets” Working Paper No. 392, Asian Development Bank Institute, October 2012. pp. 3-4. 65 Bernard Shull,“Too Big to Fail: Motives, Countermeasures, and the Dodd-Frank Response” Working Paper No.

709 in The Levy Economics Institute Working Paper Collection Hunter College of the City University of New York,

Feb. 2012 pp. 5-6. 66 For a detailed look at new capital standards for Federally Regulated Depository Institutions, see Figure 7.

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Comparing Basel III Standards with Dodd-Frank Requirements in the U.S.

Basel III’s efforts to enhance the resiliency of the banking sector by increasing required capital

levels, introducing new quantitative liquidity requirements, and supplementing the risk-based

capital framework with a leverage ratio is in line with the regulatory changes introduced by

Dodd-Frank. The primary difference between the Dodd-Frank reforms and those outlined by

Basel III is in the greater emphasis Dodd-Frank places on identifying and monitoring

systemically important financial institutions (SIFIs), and raising the regulatory standards for

these institutions well above Basel III minimums.67 For instance, Dodd-Frank enforces a

leverage ratio of at least 6.5 percent – compared to 3 percent under Basel III – when the

Financial Stability Oversight Council identifies a firm as “a grave threat to financial stability.”68

While the Basel Framework also imposes more stringent capital requirements for institutions

identified as Global Systemically Important Banks (G-SIBs), Dodd-Frank goes further in

establishing heightened supervisory standards, including an annual stress test (DFAST) and

comprehensive capital analysis and review (CCAR) for the largest bank-holding companies.

The stress testing process is a key component of regulatory reform in the U.S. and represents a

major difference with Basel III, where there is no explicit requirement for the use of stress

tests.69 While stress tests are carried out on a bank-by-bank basis, because each institution is

tested on the same assumptions the results allow for useful cross-firm comparisons. Unlike Basel

III rules for monitoring capital adequacy at financial institutions, the stress test is forward-

67 For a detailed analysis of the more stringent U.S. approach in some areas see Shearman and Sterling LLP, “Basel

III Framework: US/EU Comparison”, September 17, 2013 68 Acharya, “The Dodd-Frank Act and Basel III: Intentions, Unintended Consequences, Transition Risk, and

Lessons for Emerging Markets”, pp.17-18 69 There is, however, a recommendation that Pillar II Supervision include stress testing in some form.

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looking and can be adjusted for different scenarios. As it pertains to capital requirements, this

tool allows regulators to see how effective the capital buffer is under various stress scenarios.70

As the goal of imposing capital requirements on banks is to limit the potential for forced

liquidations of assets which may threaten the viability of a bank, the ability to model how

effective different forms of capital are in absorbing losses is essential. While many academics

have argued for even higher levels of capital at banks,71 political resistance – both nationally and

internationally – makes imposing capital requirements significantly above current levels

difficult. By forcing banks to model how well their capital holds up in different hypothetical

scenarios, and conducting an independent stress test, the Federal Reserve limits the ability of

banks to “game” the system using questionable model assumptions, and gains valuable insights

into the risk management capability of individual financial institutions. The fact that the ability

of banks to issue dividend payments to shareholders is contingent on their ability to satisfy

regulators in the CCAR process also provides an economic incentive for banks to reduce

leverage.72 The success of the stress testing regime under Dodd-Frank has led other regulatory

authorities to copy this aspect of the U.S. model,73 reflecting to some degree a regulatory race to

the top in spite of the absence for any explicit requirements under Basel III for stress testing.74

Concluding Thoughts on U.S. Implementation of Basel III

In many ways the U.S. was ground zero for the financial crisis of 2007-2009, which quickly

spread to Europe and other countries around the globe. As a result, the U.S. was much faster in

70 2015 Scenarios for the CCAR 71 Admati, Anat R. and DeMarzo, Peter M. and Hellwig, Martin F. and Pfleiderer, Paul C., “Fallacies, Irrelevant

Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive” (October

22, 2013). 72 Fitch Ratings, “Fed Rules Modify Limits on Bank Capital Distributions”, June 23, 2014 73 For instance, both the Bank of England and the European Banking Authority have recently begun annual or semi-

annual stress testing of banks under their jurisdiction. 74 Bank for International Settlements, “The First Pillar: Minimum Capital Requirements”

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drafting legislation for financial reform than other countries, enacting a sweeping overhaul to the

rules of the financial system through Dodd-Frank in 2010.75 The swifter legislative response

gave the U.S. more influence during Basel III negotiations, which were finalized in 2011. This

first-mover’s advantage likely contributed to the U.S. being judged as largely compliant with

Basel III standards. Although the RCAP did identify two of the thirteen Basel components to be

“materially non-compliant,”76 the divergences between Basel III and U.S. rules stemmed from a

logical decision by U.S. lawmakers in light of the conflict of interest problems the crisis exposed

to eliminate the use of ratings issued by rating agencies for risk-weighting assets.77

The U.S. is significantly further along in its implementation of post-crisis financial reforms

relative to the EU. Further, because the U.S. has rebounded faster than other countries from the

recessionary effects of the crisis, its implementation of higher capital standards and other reforms

has not been as inhibited by concerns for economic growth. While the U.S. has been slow to

finalize a number of reforms mandated by Dodd-Frank and is certainly exposed to political

pressures to repeal some of the stricter aspects of these reforms, the U.S. has succeeded in setting

a standard for international regulatory reform as demonstrated in the significant overlap between

Dodd-Frank-mandated reforms and final Basel III standards.

Reasons for EU/U.S. Divergence in Implementation of Basel III

Implementation of Basel III in the EU and U.S. diverge in a number of areas. First, the criteria

for capital instruments to qualify towards regulatory minimums are stricter in the U.S. than in the

EU. Second, the U.S. significantly modifies risk weighted asset calculations under the

“Standardized Approach” while the EU leaves this largely unchanged. Third, the U.S. introduces

75 Dodd-Frank was passed in 2010, while the equivalent EU legislative response was not finalized until June 2013. 76 These Basel components were: the securitization framework; and the Standardized Approach to market risk. 77BCBS, “Assessment of Basel III regulations: United States of America”, December 2014. p.5

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a formal leverage ratio requirement above the level prescribed by Basel III, while the EU instead

leaves the use of a leverage ratio subject to the discretion of national supervisors. Fourth, the EU

rules govern all credit institutions and investment firms, while U.S. rules govern only banks and

systemically-important financial institutions. Fifth, the EU exempts corporates, sovereigns, and

pension funds from the Basel III credit valuation adjustment charge aimed to account for

counterparty exposures and operational risk, while the U.S. does not. Finally, as discussed

earlier, the EU prohibits member states from imposing higher capital requirements than those

applicable under CRD IV.78

These divergences reflect a number of different factors. Among these are: contrasting regulatory

frameworks; the nature of credit intermediation in the two jurisdictions; and significant cultural

and political differences between the EU and U.S. resulting in differing priorities for financial

reform. This concluding section looks at each of these reasons for divergence in more detail.

Differences in the Structure of European and American Financial Systems

The financial systems in the EU and U.S. are fundamentally different. While banks remain the

dominant suppliers of capital in Europe, bank assets as a share of the financial industry in the

U.S. has declined steadily over the past three decades and now represents only around 20 percent

of total financial industry assets. Meanwhile, even since the adoption of the Euro as a common

currency, banks have maintained roughly 57 percent of all financial industry assets in Europe. 79

The increasing size of the non-banking sector in the U.S. can be attributed to a number of factors,

including the growth of securitization and financial companies.80 In the 1970s and 1980s, volatile

78 Shearman and Sterling LLP, “Basel III Framework: US/EU Comparison”, September 17, 2013. pp.4-5 79 See Figure 9 80 Minoru Aosaki, “Implementation of Basel III: Economic Impacts and Policy Challenges in the United States,

Japan, and the European Union”, Shorenstein APARC Working Papers, February 2013. p.18

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interest rates forced changes to the traditional banking model in the U.S. and led many investors

to move their money from banks barred from paying interest on deposits above a prescribed

threshold by Glass-Steagall’s Regulation Q. The result was a rapid decline in the ratio of demand

deposits in commercial banks to GDP, falling from 30 percent to 5 percent between 1950 and

2000. This indicated that even after interest rates normalized, large depositors had found other,

less expensive ways to store their cash. As Robert Lucas puts it, “These processes of substitution

scattered demand deposits out into the world of shadow banking and largely ended the

constraints imposed by Glass-Steagall. The Act’s repeal in 1999 was just a formality.”81

In Europe, conversely, capital markets remain relatively fragmented and very few companies

make use of non-bank financing.82 This means that banks are in some ways more important to

the health of the real economy in Europe than they are in the U.S., implying higher costs to

increasing bank capital requirements. It is not surprising, therefore, that the EU has been

reluctant to raise capital requirements much beyond Basel III minimums, and in some instances

has made exceptions that result in lower capital requirements than recommended under Basel III.

The U.S. is not as dependent on its banks for capital and so, given the significant costs incurred

by the government in bailing out these institutions in the sub-prime crisis, its more aggressive

approach to bank regulation is not unexpected. Ultimately, there is a tradeoff in raising capital

levels between increased resiliency in the financial system and lower potential credit growth,

which may result in slower economic growth. The EU and U.S. have come out on different sides

of this debate in part because of the divergent paths of economic recovery since the initial

financial crisis of 2007-2009.

81 Robert E. Lucas Jr. “Glass-Steagall: A Requiem” in American Economic Review: Papers and Proceedings 2013.

Vol. 103, Issue 3 45-46. 82 European Commission, “Building a Capital Markets Union”, Green Paper, February 18, 2015.

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Contrasting Regulatory Frameworks of EU and U.S.

The supervisory structures in the EU and U.S. are very different. In the EU, banks were

previously regulated by a patchwork of national regulators that agreed to frameworks for

coordinating their regulatory policies. This form of light integration proved inadequate in dealing

with failing financial firms with significant cross-border and cross-jurisdiction operations.83 As a

result, Europe introduced a new supervisory structure that revolved around what became known

as the Single Supervisory Mechanism (SSM). While there would still be separate agencies at the

European level responsible for the banking sector, the securities market, and insurance

companies respectively, reforms have emphasized the importance of creating a Single Rulebook

under the authority of the SSM that would reduce the discretion of national regulators in

supervising firms headquartered in their country.84 This centralization of supervisory

responsibilities has coincided with the creation of the Single Resolution Mechanism (SRM),

which creates a form of risk-sharing for potential contingent government liabilities in the event

of a failure of a large financial institution.85 The movement towards a more centralized

regulatory structure reflects the desire to enhance financial integration discussed earlier. In their

effort to create regulatory uniformity, EU Basel III implementation efforts are subject to

substantial compromise and a bias towards the lowest common denominator, making higher

standards for bank regulation than prescribed by Basel III unlikely.

83 Masciandaro, Nieto, and Quintyn, “Will they Sing the Same Tune? Measuring Convergence in the new European

System of Financial Supervisors”, IMF Working Paper, July 2009. 84 Michael Emerson and Alessandro Giovannini, “European fiscal and monetary policy: A chicken and egg

dilemma” Instituto Affari Internazionali, December 2013. 85 Veron, “Europe’s Single Supervisory Mechanism and the Long Journey Towards Banking Union”, Peterson

Institute for International Economics Policy Brief, December 2012.

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The U.S. conversely has a relatively fragmented supervisory system, with multiple regulators

depending on the type of institution, the activities of the institution, and the markets involved.86

As a result of the complicated regulatory structure, it is possible for a single institution to have

multiple regulators, making supervisory coordination difficult.87 Although Dodd-Frank reformed

some aspects of financial regulation, it largely left in place the pre-crisis supervisory structure;

the only significant change has been the creation of the Financial Stability Oversight Council

(FSOC), which is placed on top of the existing regulatory framework.88 While the FSOC is

designed to address coordination issues and has the power to designate non-bank financial firms

as “systemically important”, subjecting them to oversight by the Federal Reserve, it lacks

sufficient authority to serve as a true single supervisor of the financial system.89 As a result,

Basel III implementation is more likely to reflect the views of the Federal Reserve which, in its

role as prudential supervisor of bank holding companies and systemically important financial

institutions, has strong incentives to ensure that firms under its supervision do not fail. Therefore,

the U.S. regulatory structure is also more flexible in its approach to implementing Basel III, as

demonstrated by the willingness of regulators – particularly the Federal Reserve – to raise

standards above prescribed minimums under Basel III.

Political Differences in EU and U.S.

The final major reason for divergence between the EU and U.S. in their approaches to

implementation of Basel III is different political systems and priorities in the two jurisdictions.

The EU’s primary mission is ultimately to further European integration. Since the Schumann

86 Edward V. Murphy, “Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy for

Banking and Securities Markets”, CRS Report R43087, January 30, 2015. 87 See Figure 11 88 See Figure 12 89 Murphy, “Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy for Banking and

Securities Markets”, CRS Report R43087, January 30, 2015. pp. 28-29

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Declaration led to the creation of the European Coal and Steel Community in 1951, Europe has

been on a path “towards ever closer union.” In Europe, the hope was – and still is – that

economic and financial integration leads to institutional and political union within Europe that

makes future violent conflict nearly impossible.90 But while this goal may still be at the center of

the EU’s mission, it is at once fighting for more centralized power while struggling to please

various interest groups within Europe as a path to gaining political legitimacy.91 As Enrico

Spolaore explains: “The history of European integration is complicated, with a big cast of actors

including governments, technocrats, interest groups, and voters, who in turn pursue a range of

economic and political goals.” 92 These competing interests, along with a constant tug of war

within Europe between a desire for national sovereignty and the goal of greater integration,

makes for an environment where reforms are often incremental. Conversely, however, the

maturation of institutions at the European level has made reforms more difficult to water down

once enshrined within EU law.

The political system in the U.S. reflects its people’s deep skepticism of centralized power since

the nation’s independence. Congress is divided into two houses, the Senate and the House of

Representatives. These bodies have the ability to write legislation, but the President can veto any

bill that he does not agree with even if both parts of Congress have passed the bills. Finally, the

judicial branch can review and overturn any of the laws passed by Congress and signed into law

by the President if it deems the law to be “unconstitutional.”93 The result is the government of

90 Enrico Spolaore, “What is European integration really about? A political guide for economists” Journal of

Economic Perspectives vol. 27 no. 3 (Summer 2013) pp. 125-144. 91 Michael Emerson and Alessandro Giovannini, “European fiscal and monetary policy: A chicken and egg

dilemma” Instituto Affari Internazionali, December 2013. 92 Enrico Spolaore, “What is European integration really about? A political guide for economists” Journal of

Economic Perspectives vol. 27 no. 3 (Summer 2013) pp. 125-144. p.125 93 The White House, “Our Government”

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“checks and balances” where it can be very difficult to do much of anything as any law requires

the support of numerous stakeholders, each with their own interests. Given this political

environment Congress largely brushed over many of the details regarding how objectives

outlined in Dodd-Frank would actually be implemented, instead giving individual regulators the

authority to write the specific rules.94 The Federal Reserve, which is the primary prudential

regulator of the banking sector, operates independently from Congress and does not rely on

Congressional appropriations to fund its operations.95 As a result, it had significantly greater

flexibility in its implementation of Basel III in the U.S. than did EU bureaucrats in drafting CRD

IV. Therefore, the political system in the U.S. also proved to be a positive for the stringent

implementation of Basel III by American regulators. Ultimately, however, the highly contentious

U.S. political environment in which the financial industry still holds significant influence may

open the door for overly-strict rules to eventually be watered down or repealed.

Concluding Thoughts

The EU and U.S. Basel III implementation processes are by no means completed. While early

evidence suggests that the U.S. has gone further in adopting Basel III reforms, there is still much

to be done on both sides of the Atlantic before final judgments on the quality of the reform

processes can be made. As with most efforts at regulatory reform, unfortunately, we are unlikely

to know the effectiveness of the new supervisory systems until the next crisis hits.

94 Henry B. Hogue, Marc Labonte, and Baird Webel. “Independence of Federal Financial Regulators”, CRS Report

R43391, February 24, 2014. 95 Congressional Budget Office, “The Budgetary Status of the Federal Reserve System”, February 1985.

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Figure 1: Evolution of Basel Standards

Source: Latham & Watkins, “Regulatory Capital Reform under Basel III.” March 2011. p.8.

Craig N. Hardt Implementing Basel III: A Comparison of the EU and U.S. Spring 2015

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Figure 2: Basel Committee on Banking Supervision reforms – Basel III

Strengthens microprudential regulation and supervision, and adds a macroprudential overlay that includes capital buffers.

Source: Bank for International Settlements, Basel III Summary Table.

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Figure 3: Indicator-based measurement approach and Bucketing approach

Source: BCBS, “Global systemically important banks: assessment methodology and the additional loss absorbency requirement”, July 2011.

Table 1: p.5

Table 3: p. 15

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Figure 4: Basel III phase-in arrangements

Source: Bank for International Settlements (2014)

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Figure 5: Increase and Dispersion of European Sovereign Spreads 2006-2011

Source: Ashoka Mody and Damiano Sandri, “The Eurozone Crisis: How Banks and Sovereigns Came to Be Joined at the Hip”, IMF

Working Paper No.11/269, 2011. p. 4

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Figure 6: Overview of Adoption of Capital Standards in EU

Source: BCBS, “Assessment of Basel III Regulations: European Union”, December 2014. p.58

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Figure 7: Capital Standards for Federally Regulated Depository Institutions

Source: Edward V. Murphy, “Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy for Banking and

Securities Markets”, CRS Report R43087, January 30, 2015. p.36

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Figure 8: Overview of Adoption of Capital Standards in U.S.

Source: BCBS, “Assessment of Basel III Regulations: United States of America”, December 2014. p.65

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Figure 9: Bank Assets as a Share of Financial Industry 1987-2007, Breakdown of the U.S. Financial Sector

Source: Minoru Aosaki, “Implementation of Basel III: Economic Impacts and Policy Challenges in the United States, Japan, and the European

Union”, Shorenstein APARC Working Papers, February 2013. p.20

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Figure 10: Financial Market Supervision in the Emerging Banking Union

Source: Michael Emerson and Alessandro Giovannini, “European fiscal and monetary policy: A chicken and egg dilemma” Instituto

Affari Internazionali, December 2013.

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Figure 11: Regulatory Oversight of J.P. Morgan

Source: Edward V. Murphy, “Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy for Banking and

Securities Markets”, CRS Report R43087, January 30, 2015. p.3

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Figure 12: Organizational Structure of FSOC

Source: Financial Stability Oversight Council, “FSOC 2014 Annual Report”