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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”