MADNESS OR DESPAIR AT THE HIGHEST LEVEL IN EUROPE? European leaders are against the increase of bank capital

The global financial crisis, after which large international banks needed the help of governments in order to survive, has led to the demolition of the myth that financial institutions can manage the risks that they have assumed.

At the national level, especially in Europe, the framework for valuation and risk management has been built on agreements published by the Basel Committee of the BIS (Bank for International Settlements).

The first agreement for bank capital adequacy according to risk, Basel I, was published in 1988 and entered into force for banks in the G10 countries in 1992. At that time, the focus was on credit risk and bank assets were divided into five risk classes, which have been assigned risk weights of 0% (cash, gold and bonds issued by governments of countries where banks were operating), 20% (financial instruments like mortgage bonds rated AAA), 50% (municipal bonds, residential mortgages) and 100% (mostly corporate loans).

Minimum capital adequacy rate, calculated as the ratio between capital and risk-weighted assets, was set at 8%.

The next agreement, Basel II, started from the premise that banks can better assess risk and created a more flexible framework for calculating risk-weighted assets, including the one based on internal models of financial institutions.

Minimum capital adequacy rate remained at 8%, but this could be achieved more easily by manipulating data and assumptions of risk models.

The new regulatory framework has created perverse incentives for banks, those of assuming risks that were poorly understood, as proven by the reality shock represented by the global financial crisis.

After the severe phase of the crisis, the Basel Committee (BCBS) went again to the drawing board for "improving" Basel II. One of the first changes was the introduction of a minimum threshold for the leverage ratio (the ratio of total equity to total assets), an indicator that does not take into account the risk-weighted assets.

The reason? Supervisors found that the risk weights for the same type of exposure show strong variations at the level of international banks after the approval to use internal models.

As a result of such "financial engineering", capital requirements remained unchanged or even decreased, while the balance sheets have expanded. Unfortunately for banks, the crisis has failed to distinguish between assets and risk-weighted assets when hit, and "adequately capitalized" proved an extremely expensive illusion.

In addition to the use of leverage ratio in the regulatory framework, the Basel Committee has proposed comprehensive reform of how to assess risk-weighted assets by introducing minimum thresholds of risk weights. In this way it aims at "reducing the excessive variability of risk-weighted assets", as stated in a press release on the BIS website regarding the development process of Basel III.

The press release also states that the group of central bank governors and heads of supervisory institutions approved new reforms and Basel III will be completed by the end of the year. "Completing the post-crisis reforms Basel III will complement and help return confidence in capital adequacy based on risk-weighted assets," said Mario Draghi, president of the group within BIS.

Will it be that simple? Not at all. Banks have expressed strong dissatisfaction at every stage of negotiations, and now, when they seem to have lost the "battle", they went for help to their own "supervisory" institutions.

Bloomberg recently wrote that "Europe threatens uprising against reform capital adequacy rules." The article describes "the heated meetings of regulatory institutions from European countries, including Germany and Italy, and representatives of the Basel Committee on Banking Supervision". The European authorities asked that "the changes to how banks assess credit, market and operational risks must be scaled back and slowed down".

Some European officials have gone further and said they will not adopt new measures in national law (Basel II is the basis for the European Capital Requirements Directive).

Even Wolfgang Schaeuble, Germany's finance minister, insisted on the "minimization of any increase in bank capital requirements" and emphasized that "the new rules will not have negative consequences for certain regions", as stated by Bloomberg.

The American news agency shows that "new regulations for bank capital adequacy have created divisions in the German government", which took into account the approval of a resolution requesting the BCBS "to ensure that the rules will not lead to an increase in capital requirements".

The resolution was postponed amid protests from the Social Democratic Party, which wants to preserve the appearance of harsh attitude towards banks.

On the other side of the Atlantic there is another kind of "rebellion", that of the large financial institutions against the "dictatorship" of Federal Reserve. A nonprofit banking organization, Committee on Capital Markets Regulation, which includes all the big names on Wall Street, has published a study which states that "Federal Reserve broke the law by adopting key measures of the stress tests", according to an article in the Wall Street Journal. US financial daily writes that it does not happen too often to see banks contemplating to sue regulatory institutions" but "such an option is taken into account".

Amid significant capital deficit, especially in the European banks, their attitude is understandable, especially as the exorbitant privilege they enjoy, that of creating money by lending, has no value due to the lack of demand for credit.

What can not be understood is the attitude of the European governments, especially when it comes from the promoters of draconian austerity in the periphery countries of the euro area.

How is it possible to ignore the lessons of the crisis and the huge cost of the bail-out operations? Then how is it possible to promote the bail-in of the bank deposits, approved much faster than new agreement on capital, if you do not support also a radical change to what is known as "banking culture", including a return to unlimited liability for managers and shareholders of financial institutions?

The attitude of European politicians towards banks might seem hard to explain at first. Are they just incurable idiots or simply desperate because they see the collapse of their "European dream", and, as a result, they have lost even the minimal survival instincts and redefined the democratic legitimacy by saving banks at any price?