The EU banking package: in Basel we trust

Speech by Elizabeth McCaul, Member of the Supervisory Board of the ECB, at the Working Group Financial Services on “Finalising the details – the revised EU bank prudential framework” hosted by the Kangaroo Group

Brussels, 6 December 2022

Introduction

Thank you very much for inviting me back to join another discussion of the Kangaroo Group.

Your choice of topic – the finalisation of the EU banking package – is a very relevant one. As the European Parliament and the Council are finalising the details, I would like to propose three yardsticks – or rather questions – related to the legislative amendments. First, do they make our banking system safer and sounder? Second, do they make the framework simpler? And third, do they contribute to a level playing field internationally and prevent regulatory arbitrage?

European banks – ensuring trust and credibility

Let me first focus on the implementation of the Basel III reforms. These reforms were the Basel Committee’s central response to the global financial crisis. As the memory of that crisis fades, I sometimes fear that people forget why we embarked on this journey in the first place.

And in that lies an important risk. As the saying goes, those who fail to learn from the mistakes of the past are doomed to repeat them. The Basel Committee tried to draw the lessons from the global financial crisis and I believe it would be in the EU’s best interest to heed those lessons.

Having divided my professional life between the United States and Europe, I would like to give you a bit of an international perspective. The Basel standards are a bedrock of the international financial system, ensuring the proper functioning of global financial markets and a level playing field among banks. But these standards can only be effective if all signatories commit to implementing them in their jurisdictions – fully, faithfully and in a timely manner.

This is regularly checked by the Basel Committee through its Regulatory Consistency Assessment Programme (RCAP). The RCAP assesses whether the implementation of the reforms is consistent with the Basel framework. The last RCAP of the EU was completed in December 2014. Back then, the Basel Committee considered the EU to be “materially non-compliant”. This was the second-worst grade possible.

In the Commission’s 2021 proposal, some pre-existing deviations were largely kept, and some additional ones were introduced, both temporary and permanent. And in the legislative process in both the Council and the Parliament, there are now calls for additional deviations to be introduced.

This will obviously have an impact on the Basel Committee’s future assessment of the EU’s implementation of Basel III. If all deviations under discussion make it into the final legislative package, we see a risk that the Basel Committee may even give the EU the lowest possible grade: “non-compliant”.

The financial system is built on trust. One of the key objectives of the Basel III standards is to restore trust in and credibility of the risk-weighted capital framework. Watering down the rules puts at risk the trust that European banks currently enjoy internationally. I understand the concerns about the capital impact of implementing Basel III. But, as ECB research shows^[1], short-term gains in terms of basis points dwindle in comparison to the long-term benefits of having a strongly capitalised banking system. What is at stake here is the reputation and competitiveness of the European banking sector.

But this matters not just for the reputation of the EU and its banks. It also matters for the resilience of our banks. Each deviation has a concrete impact: it means that there is an additional pocket of risks that may not be sufficiently covered in banks’ balance sheets.

In benign economic conditions, adhering to global standards might be considered an unpleasant obligation that can be easily tweaked to cater for the old ways of doing business. But the lessons of past financial crises are clear: if economic circumstances deteriorate, sparks of doubt over the reliability of the capital framework and lack of transparency can easily ignite a crisis of trust in the banking system, with devastating consequences for the economy. We are not calling for faithful implementation of Basel III for the sake of compliance; we are doing so because it is the best guarantee of the safety and soundness of our banks.

Concretely, I am concerned about the introduction of further deviations from Basel III in different areas.

Real estate markets are stretched and may see significant corrections in some segments and regions, and yet many deviations on real estate exposures are being put in place. Small and medium-sized enterprises and corporates are likely to struggle in the face of many economic and geopolitical headwinds, and yet several deviations on corporate exposures are being proposed. Equity exposures are inherently much riskier, and yet there are more and more deviations being considered from the higher risk weights envisaged by Basel III. Counterparty credit risk is on the rise in view of higher volatility in energy derivative markets, and this has led to significant margin calls in recent months. Yet the proposals would allow banks to underestimate their derivative exposures under the output floor.

I have also proposed simplicity as a reform objective. Unfortunately, our current capital framework is very far from being simple. Including additional deviations from the Basel standards will make the system even more complex. This increases costs for banks, investors and supervisors alike.

Making supervision work

Beyond the implementation of the Basel reforms, the quality of supervision is also key to fostering trust in the banking system. We strive to contribute in the best way possible, but we also need to be empowered to do so. This leads me to some important changes in the Capital Requirements Directive (CRD VI).

First, harmonising the framework for our “fit and proper” assessments, which guides the way we assess whether bank directors are fit for their job. This framework is a patchwork at the moment, as Member States have implemented the relevant provisions of the CRD differently. This brings complexity to supervision, which faces different process rules in different countries. Therefore, a harmonised legal basis for fit and proper assessments and processes would further strengthen our ability to promote that qualified people are on banks’ management bodies and in key positions across the entire banking union. The Commission proposal represents an important step towards the envisaged harmonisation. We are convinced that such a harmonised framework can be implemented in a proportionate way, duly respecting the specific governance arrangements in certain sectors. Poor governance is often at the core of banking crises and having capable decision-makers on the boards of banks is one of the most effective ways of preventing crises in the first place.

Second, ensuring a harmonised approach to dealing with third-country branches. Currently, these rules vary significantly across Member States. Regulatory fragmentation opens the door to potential arbitrage and creates gaps where risks are not well understood or supervised. It is therefore of the utmost importance that we align these practices across the Single Market and ensure a level playing field for third-country groups and EU credit institutions.

And third, making sure that banks properly address environmental, social and governance (ESG) risks. Banks are essential in financing the transition of the economy to meet climate-related targets. We welcome the Commission’s proposal, which requires banks to develop transition plans and entrusts us with requiring corrections if risks arise from any misalignments with these plans.

Conclusion

Let me conclude.

It is essential to foster trust in the banking sector and increase its resilience in a very volatile economic and political environment. I have proposed three yardsticks guiding the discussion on the finalisation of the banking package: soundness, simplicity and ensuring a level playing field. If we want the Basel implementation in the EU to serve its purpose, we need to be more ambitious to meet these objectives.

Thank you very much for your attention.