Synopsis 02: Risk-Weight Based Financial Regulation in the EU from 1934 to the present

This synopsis is the continuation of synopsis 01: Learning from the Past – 4 Reasons Why German Banks Failed in 1931?

1.1.Introduction of Risk-Weight Based Financial Regulation in Germany – the German Banking Act 1934

This banking crisis revolutionized Germany to the extent that it introduced the German Banking Act (GBA) in 1934, which defined capital as equity and laid the foundations for a modern banking system in Europe with two fundamental features: first, to inscribe legislation in which prudential metrics were articulated and enforced by the supervisory authorities, and second, to familiarize risk-weighted regulations, a feature which is now the central pillar of the international financial regulatory framework [8]. The GBA introduced various ratios, such as a liquidity coverage ratio, risk-weighted capital ratio, and a large exposure limit, which had to be maintained by banks and threshold values defined by the Reichsbank bank-by-bank basis. As well as defining capital and liquid assets, it also introduced restrictions on capital distribution if the legal requirements were breached and a bonus remuneration policy for the senior management in the banks [18].

1.2. Banking Regulations in Other European Countries 

Although the leverage ratio was introduced for the first time by Denmark in Bank Act N0. 122 of 15 April 1930, which mandated that the equity of a bank must be a minimum of 10% of their total liabilities, it was the GBA that was genuinely innovative with its embryonic risk-weighted capital ratio, where the total liabilities deducted from liquid assets were not permitted to exceed the prescribed percentage of the regulatory capital determined by the supervisory authority. This deduction of liquid assets is the equivalent of giving them a 0% risk-weight score and was the first of its kind in any European banking law [18].

By the 1930s, it was evident that some European countries, such as Germany, Sweden, and Denmark, had embarked on more formal banking regulations. In 1941, the Vichy regime created the first French banking law in which it introduced a minimum capital requirement but did not provide specifications on the definition of the ratio [19]. By that time, banking supervision in the UK was based on the Governor of the Bank of England’s informal “raised eyebrow” and focused principally on liquidity rather than on capital [20]. Even though the Bank of England considered specific ratios to assess the financial health of a bank, the Bank of England ratios were more flexible than in Germany [21].

After the Second World War, European countries continued to strengthen their risk-weighted capital and banking regulations, mainly led by Germany. In 1961, the GBA was amended, and the “Federal Banking Supervisory Office” was assigned the task of developing principle-based mechanisms for assessing capital adequacy. These were further revised in 1972 to introduce the evolution of risk weights by explicitly allocating 50%, 20% and 0% to different credit types [22]–[24]. In the 1970s, the Bank of England (BoE) helped London and Scottish clearing banks to develop regulatory risk-weighted ratios [25]. By the end of the 1970s, five of the nine European Economic Community (EEC) member states used a risk-weighted approach and large exposure limits for financial regulation, and seven ECC member states permitted subordinated debt to be counted as capital, with Denmark allowing up to 40% and Luxembourg up to 50% [26]. At that time, Italy had its own formal capital regulation. In the 1980s, the BoE introduced more accurate capital adequacy measures to enhance its statutory responsibility for banking supervision, which it had received the year before. It recognized two ratios, such as leverage ratio and a risk-asset ratio encompassed seven risk weights fluctuating from 0% to 200%. However, the BoE did not introduce a minimum ratio [25]. In the USA, before 1983, regulators did not possess the statutory powers to issue directives on capital or banking issues. As a result, risk-weighted ratios were used by the Federal Reserve Board mainly as examination tools but not as legally binding minimum criteria for the US banking system [20].   

1.3. Introduction of Risk-Weight Based Financial Regulation in the Basel Accord and the EU

The pre-Basel world was mainly based on risk-weighted ratio constraints on banks, a situation that was neither harmonized nor legally accepted either within or outside of Europe. As a result, in 1988, the Basel Committee on Banking Supervision (BCBS) harmonized all of these financial rules into a single risk-weighted capital ratio compacted with several tiers of capital, known as the 1988 Basel Capital Accord or “Basel I”. Even though local jurisdictions were not under any legal obligation to follow this single ratio, the majority of regulators within the banking sector shifted to the single ratio within and outside of Europe [8], [27], [28]. However, European financial regulators were aware that “Basel I” did not represent all the rules required for idyllic financial regulation, even though it facilitated the crucial discourse internationally on regulating banks using risk-weighted capital ratio. For instance, “Basel I” did not cover the market risk, nor did it include leverage ratio or liquidity metrics [27]. In 1996, for the first time, the Market Risk Amendment permitted banks to model their capital requirements themselves to emulate best practices in credit risk modeling. The Basel Committee utilized the “Value-at-risk”(VaR) methodology for market risk assessment, which JPMorgan introduced and popularized. It concluded that “a moderate amount of supervisory guidance […] could substantially reduce the dispersion in the results” [28]. However, as the capital was not always associated with the increase of the risk, the market risk amendment was widely criticized as inadequately “risk-sensitive” [29].  

The concerns on the shortfalls of “Basel I” on the issues related to market risk-sensitivity convinced the Basel Committee to produce a revised set of regulations in 2004, known as “Basel II”. It extended the scope of internal banking models in order to incorporate all risk classes not included in “Basel I”, such as credit risk. Besides, “Basel II” permitted a group of banks – those lacking the capability to model these required risks themselves – to use so-called “standardized approaches” under which capital requirements were based on external agency ratings [30]. In 2006, the Capital Requirement Directive transposed “Basel II” into European law. More particularly, recital 37 of Directive 2006/48/EC stated that the minimum capital requirements of credit institutions mentioned in this Directive and the minimum capital provisions given in Directive 2006/49/EC are equivalent to the provisions of “Basel II”. These two Directives are collectively known as Capital Requirements Directives I (CRD I).  

1.4.The Complexity of Basel II and its Effects in the Global Financial Crisis of 2007-08

The emergence of complexity in “Basel II”, however, presented itself on two fronts – (a) on the one hand, the total number of parameters had gone down as “Basel I” and “Basel II” were based only on a single ratio, in contrast to the multiple ratios incorporated before, for instance in the German Banking Act of 1934 and its amendments, and (b) the number of calculations required to understand a single risk-weighted ratio, on the other hand, enhanced the level of complexity. For example, for a large bank, more calculations were required to understand a single parameter's behavior needed a generation ago than to understand several million today [31], [32]. The effect of (b) far compensated for (a) [8]. Even though the principal purpose of the Basel Accord was to represent the cumulative complexity of the contemporary banking system under its control in a harmonized way so that all players in different jurisdictions abide by the same rules, the global financial crisis of 2007-08 proved that at least three major factors were misrepresented in such an internationalized financial regulatory framework: (a) the meaning of capital, made up of six different tiers each with maximum and minimum independent requirements, (b) the risk weighting, that was not adequate for analysing and understanding the fundamental risks associated with financial instruments, and (c) the lack of other ratios in the Basel Accord, such as the accounting leverage ratio [8], [33]. These factors are discussed briefly below. 

1.5. The misrepresented factors in the Basel Accord in the run-up to the financial crisis of 2007-08

Definition of capital: In the Basel Accord, the definition of capital is made up of the following six tiers – Core Tier 1, Non-Innovative Tier 1, Innovative Tier 1, Upper Tier 2, Lower Tier 2, and Tier 3. A set of rules was established in order to recognize the maximum and minimum levels necessary for meeting the 8% overall minimum ratio. While Tier 1 capital comprised at least 50% of the minimum 8% and intended to absorb losses, other tiers of capital were intended to be used after resolution. The tier-oriented regulatory capital system was severely affected by the financial crisis of 2007-08 in, at least, the following two ways: (a) Financial institutions, on the one hand, overvalued Tier 1 capital to ensure their solvency. As a result, banks were discouraged to cancel coupons or cancel or concede payments. On the other hand, Tier 2 and Tier 3 capital was unconnected to the context. Because bailed-out banks were supported by capital injection from governments and therefore these capitals were of little use for absorbing losses [34], and (b) two interconnected legal issues were affecting the regulatory capital limits. First, there was no legally enforced harmonized single rule for the various interpretations and inferences of the meaning of a regulatory definition of capital across the jurisdictions. Second, there were no legal disclosure requirements on the structure of the capital of banks and financial institutions [35]. Banks reaped the benefits of this situation. As a result, before the crisis, banks shifted their “Core Tier 1” capital to “Innovative Tier 1” and “Tier 2” capital [36].

Risk weights: The risk-sensitive capital measures are not able to differentiate ex-ante between survival and default [32]. Additionally, the risk-weighted ratio is not adequate in times of difficulty [37]–[40]. For example, UK banks' total assets’ capital requirements dropped from about 5% in 1998 to around 2.2% in 2010 [8]. This type of decline was evident in many other European countries over the same period [41]. This could be explained by banks investing in safer assets; however, the crisis implies that this is not the case. The other evidence-based explanation is that banks misused the framework's limitations by generating investments in assets where the risk was low in relation to its returns. For example, investing in trading book exposures as their average risk-weight was lower than in the traditional banking book. In general, this practice tended to benefit the trading book as it required capital requirements to be based on the variations in prices. In addition, it helped to increase volatility and exceed banking book requirements [8]. However, during the crisis, the opposite situation occurred, leading to the lowest risk-weight based capital requirements to be implemented. The Basel Committee on Banking Supervision, in its reports of 2016 [42], [43], specified that the under-capitalization of banks before the financial crisis of 2007-08 was aided by the inability of banks to a position where capital requirements were lowest.

Lack of other ratios such as leverage ratio: In reality, it is not possible to assess risk correctly. Using their own model or that of regulators, what banks do is to infer the risk that is likely to appear in the near future, based on the analysis of the past data available. Therefore, risk-weight based assessment is limited with its practicality to “known knows” – that is, to understand risks from what we know and have seen and can quantify [8]. This approach clearly failed to predict the financial crisis of 2007-08. Several studies found that the leverage ratio, in contrast to the risk-weighted ratio, is a better tool for predicting bank failure and dealing with “unknown unknowns” – that is, to understand the risks that are difficult to estimate from inside and outside of a sample [44], [45]. The “Basel II” approach was based on limiting economic leverage but not the accounting leverage. This required banks to evaluate their risks and distribute capital accordingly. Although this is a rational approach in theory, in reality, it is disposed to estimation error – both opportunistic as well as honest errors [46]. The financial crisis of 2007-08 led to accounting leverage limits being reinforced in conjunction with Basel II economic leverage limits [33]. 

1.6. Lessons Learnt from the German Banking Crisis of 1931 and the Global Financial Crisis of 2007-08

The global financial crisis 2007-08 and the deficiencies of the Basel Accord are conjoint phenomena of the lessons learned from the previous financial crises, such as the German banking crisis of 1931, since in both of these crises, banks were vulnerable due to their dependency on unreliable funding and the enormous concentrated loans that they had taken out, not because they were under-capitalized [8]. These lessons enlightened the Basel Committee to design a new framework – “Basel III” – in 2011 [47]. A critical aspect of “Basel III” is that it introduced a new definition and capital requirements level. It removed “Innovative Tier 1” and “Tier 3” capital and unified “Upper Tier 2” and “Lower Tier 2” capital. The new “Tier 1” capital is constituted with “Common Equity Tier 1 – known as CET1” and “Additional Tier 1 – known as AT1”. It also formalized a new set of principles to harmonize the suppositions from common shares. Due to these changes in capital definition, the EBA estimated that, on average, the amount of capital decreased by 17.6% and 22.5% for large and smaller European banks, respectively [48].

1.7. Risk-Weight Based Financial Regulation Is Now Embedded as a System of Financial Regulation in the EU

However, all Basel instruments – Basel I, II, and III – have been transposed in the EU, shown in Table 1.2.

In addition to the “Basel III” implementation in the EU, the CRD IV package introduced a number of important transformations to the banking regulatory framework, such as a systemic risk buffer, an enhanced transparency mechanism, a mechanism for balancing diversity in the composition of the board, increasing the risk oversight mechanism for the board, monitoring risk governance by the supervisory authority, and introducing a new remuneration framework to tackle excessive risk-taking. Most importantly, EU Regulation 575/2013, the Capital Requirement Regulation (CRR), which transposed “Basel III” into EU law and became directly applicable in all member states of the EU, reintroduced the concept and scope of “the Single Rulebook[1]”, that is to provide a single set of harmonized prudential rules that all financial institutions must respect across the EU.

The Single Rulebook will be discussed in more detail in the upcoming synopses.

[1] The term “Single Rulebook” was first coined institutionally by the European Council in 2009 in order to emphasize the goal of establishing a unified regulatory framework for all EU financial sectors – banking, insurance, fund and capital – that would complete the single market for financial services. [for details, see "Presidency Conclusions of the Brussels European Council", Brussels: European Council. 18 June 2009. p. 8.] Furthermore, the same Presidency Conclusion articulated that “the European Council also recommends that a European System of Financial Supervisors, comprising three new European Supervisory Authorities, be established aimed at upgrading the quality and consistency of national supervision, strengthening oversight of cross-border groups through the setting up of supervisory colleges and establishing a European single rule book applicable to all financial institutions in the Single Market. Recognizing the potential or contingent liabilities that may be involved for Member States, the European Council stresses that decisions taken by the European Supervisory Authorities should not impinge in any way on the fiscal responsibilities of Member States. Subject to this and supplementary to the Council conclusions of 9 June 2009, the European Council agrees that the European System of Financial Supervisors should have binding and proportionate decision-making powers in respect of whether supervisors are meeting their requirements under a single rule book and relevant community law and in the case of disagreement between the home and host state supervisors, including within colleges of supervisors. ESAs should also have supervisory powers for credit rating agencies. The European Council further emphasizes the importance of ensuring that the new framework supports sound and competitive EU financial markets.”

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