Financial Regulatory Forum

How the EU will force banks to save for rainy day

July 29, 2009

BRUSSELS, July 29 (Reuters) – The European Commission is consulting with the banking industry and others about more rules to make banks build up a buffer to ride market downturns.

It forms a basis for the European Union’s third wave of changes to its bank capital requirements rules. It also puts into law pledges made by the G20 group of countries in April to learn from the financial crisis.

The second wave of reform was proposed earlier this month and is now awaiting adoption into law by the European Parliament and EU states.

The initial reform was adopted into law in May and is due to take effect next year.

The Commission will propose a draft law in the autumn based on its document and the results of the consultation.

Here are some key elements:

DYNAMIC PROVISIONING
* Banks are already required to set aside money to cover the risk of borrowers not repaying loans. Dynamic provisioning means they must build up separate reserves to tap when markets overall turn sour.

* The extra buffer would allow banks to continue lending in a downturn and act as a brake to runaway lending during a boom.

* The extra reserve cannot be counted as part of the basic capital cushion a bank must have.

* It is proposing the Spanish “through the cycle expected loss” model or a simplified version. Spain is the only country to have introduced such rules after the bust of the early 1990s, forcing its banks to make hefty provisions for mortgage loans.

* The current financial crisis has rocked the Spanish economy and toppled its property market but banks such as BBVA and have had relatively few writedowns and did not need state help.

FOREIGN CURRENCY LENDING
* The commission plans tougher rules on banks lending in a foreign currency. Eastern European borrowers who took out Euro mortgages ran into difficulties when local currencies collapsed.

* The commission wants to stop a repeat of this by imposing “penal capital requirements” to discourage such lending.

* It is floating the idea that such loans can only cover up to half of the value of a property.

END OF GOLD PLATING
* The Commission wants to move towards a single rule book across Europe by scrapping the ability of national regulators to top up bank capital rules. Some countries have used so-called gold plating as a tactic to keep foreign banks out.

BRANCH ACCOUNTS
* The Commission wants to stop EU states demanding accounting information from foreign banks about their local operations.

* It believes this will end the need for reporting and auditing for at least 200 local bank operations although it says that savings may be modest.

COSTS AND TIMING
* The Commission said the impact on its proposed changes could be substantial and may affect how much capital banks have to lend. It wants to hear industry views on the broader cost impact and when would be best to introduce the new rules.

LEVERAGE CAP
* The Commission said it will soon finalise a proposal to introduce a form of leverage ratio to curb the kind of runaway growth in lending and balance sheets that led to the financial crisis.

* The leverage ratio forces banks to set aside a fixed amount of capital based on the size of their balance sheet.

* It ignores so-called risk-weighting, which allowed banks to brand some loans as low-risk and thereby reduce the capital they held to cover non-payment. Risk-weighting is seen by some as flawed and blamed in part for causing the crisis.

For full version of the consultation document, click here

((Reporting by John O’Donnell and Huw Jones; john.odonnell@reuters.com; +32 2 287 6817))

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