WASHINGTON — As the financial world comes to grips with the news that the European Union has no intention of implementing the final elements of Basel III, observers are scrambling to figure out how much impact the split could have on U.S. banks and global financial stability.
European Commission Vice President Vladis Dombrovskis told a banking conference in Brussels last week that the EU was planning to go its own way on credit, operational and market risk capital requirements — the final handful of capital rules in the Basel III accords that remain unfinished.
Such a public split would undoubtedly be a major blow to global banking rules and capitalization standards, but some believe his comments are a bluff designed to tone down the final Basel III agreement.
"It remains to be seen whether or not this is a negotiating position," said Hugh Carney, senior counsel at the American Bankers Association. "There are some underlying issues about what it means to not raise capital requirements significantly. What folks think of as 'significant' may vary."
Marcus Stanley, policy director at Americans for Financial Reform, isn't sure it's a bluff, but believes it's an effort by European regulators to encourage the Basel committee not to go forward with rules that would require banks to rely less on risk-based capital and more on simpler, higher leverage ratios.
"Basel has revealed these fundamental weaknesses in how risk-based capital is assessed," Stanley said. "As Europeans are realizing the weakness in their banking system, they're basically pulling out big threats to try to prevent Basel from acting on what they've found."
Others believe a split is genuine and looming, resulting in the U.S. and the EU going forward with similar but fundamentally different capital regimes. Even if Europe is making a play to weaken the final Basel rules, the U.S. is unlikely to follow suit.
"The U.S. is going to do what it's going to do regardless," said Greg Lyons, partner at Debevoise & Plimpton. "The U.S. is committed to higher capital, committed to higher liquidity requirements, and I don't think the Basel Committee not doing something would make the U.S. feel at all constrained."
U.S. regulators have routinely exceeded Basel standards and pushed the global rules to be more stringent than many other global actors are comfortable with.
Lyons said that the EU's decision to split off from Basel comes at a good time. Most of the biggest and most complicated projects envisioned in Basel III — the liquidity coverage ratio, the net stable funding ratio and basic capital ratios — have been completed and are largely in place. A bigger concern is what happens from here on out.
"The real question is what is the Basel Committee's agenda after these rules get finalized?" Lyons said. "You have to imagine that once the imprimatur of everybody acting the same … is broken, does it make it easier for states going forward to say, 'No, we don't want it.' The Basel rules could then become more of suggestions than expectations."
But Carney said that Basel rules have been moving in that direction already. For instance, the committee has a double standard for the use of external ratings to help set capital requirements. It is prohibited under U.S. law by the Dodd-Frank Act of 2010, but ratings are widely used in the EU. Those kinds of concessions have already weakened the credibility of the accords, he said.
"Basel is increasingly taking a Chinese menu approach to regulatory capital, where different jurisdictions are able to pick and choose which of the standards make sense for them," Carney said. "And if you're picking and choosing the standards, then it may make one wonder if international harmonization is even achievable."
Stanley said the risks of Basel being weakened as a global arbiter of capital rules is perhaps inevitable, but the two most important aspects of Basel are things that the U.S. is able to pursue unilaterally.
Basel originally promised an era with a single set of global regulatory standards that would help prevent the kind of regulatory arbitrage that was commonplace before the first Basel accords were negotiated in the 1980s.
But even if the EU splits off, U.S. regulators have the power to unilaterally ring-fence the domestic-based activities of foreign banks, ensuring they are well capitalized, Stanley said.
"I think the idea of a totally unified global standard is not realistic," Stanley said. "What we wanted was at least a good global floor. Basel is that floor."
The hope for many U.S. banks is that the EU's decision might add pressure on domestic regulators to simplify, or at least rethink, it approach to capital and liquidity.
Republicans and some Democrats in Congress have criticized Basel and Dodd-Frank as requiring capital levels in excess of what is necessary for financial stability at the expense of putting U.S. banks at a competitive disadvantage. The fact that the EU may break from the Basel standards explicitly to further a pro-growth agenda is likely to encourage those voices going forward, Carney said.
"The Collins amendment and the inability to use ratings are going to create a lot of pressure [on] the U.S. to think of how to simplify the regulatory capital framework," Carney said. "If different jurisdictions are backing away from rigid Basel compliance, that could — and hopefully would — change how the U.S. regulators view Basel compliance."
Still, European regulators may think twice about lowering capital requirements after troubles surfaced at Deutsche Bank, which has fueled concerns about the stability of the financial sector in Europe.
"As we're seeing with Deutsche Bank, the greater health of the U.S. banking system, in terms of higher levels of capital than Europe, is a major economic strength for us," Stanley said. "We shouldn't let ourselves get dragged down by the Europeans."
Karen Shaw Petrou, managing partner of Federal Financial Analytics, said the EU announcement at the very least puts the U.S. in an awkward position of having to choose between higher standards and poor global competitiveness for domestic institutions on the one hand and backing off of its regulatory vision on the other.
"They have to cross their fingers and click their heels twice and hope that Basel can be functional, because if it isn't, they face some very hard choices that they would prefer to avoid," Petrou said.