Bank Leverage Now in EU's Hands

The ball is in the EU's court to show just how much international financial coordination will be a race to the top, or to the bottom.
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The ball is in the EU's court to show just how much international financial coordination will be a race to the top, or to the bottom. Over the last two weeks, US regulators have approved "Basel III" banking regulations that will require banks to increase the amount and quality of capital used to finance their operations. Under the new rules, U.S. banks will not only have to maintain common equity equal to at least 7% of risk-adjusted assets, but they will also, under new "leverage ratio" rules, have to hold additional amounts of equity relative to their debt regardless of risk, with the biggest banks certain to be subject to rules stricter than even the Basel III approach.

The question now is how Europe will react. On April 16, the European Parliament approved the packet of legislation known as CRD IV, which like the Fed largely implements Basel III. As in the US, its rules boost the amount of capital a financial institution must hold relative to risk-weighted assets. Less clear, however, is what the EU will ultimately do with regards to leverage.

There may be skepticism from some EU quarters about going the extra mile. Leverage ratios can be gamed and can even incentivize non-banks to step in to take on the debt normal banks can't. Plus Brussels has already taken a tough stance on banker bonuses, credit rating agencies and a financial transaction tax that many EU officials feel Washington has shunned. But heightened leverage requirements should still be seriously considered. First, they provide an additional buffer and protection against assessments of bank risk that have proven notoriously difficult to get right. Second, they are relatively simple to enforce, and when crafted the right way can allow market participants and regulators to compare banks across borders in ways that may not always be possible under normal risk weighted capital regimes. And third, they can be flexibly administered based on institutional size, sparing smaller and medium sized banks from the most onerous costs.

Finally, by adopting a sensible, scalable leverage regime, financial authorities on both sides of the Atlantic can highlight the fact that international cooperation can be a race to the top in both efficiency and safety. The last minute deal inked by EU and US derivatives regulators leaves as many questions as answers as to just how the two regimes will ultimately interact. And distrust on both sides is already such that attempts to tack even helpful mechanisms of regulatory coordination to transatlantic trade negotiations face an uphill battle. At this point, moving in synch on an issue as important as leverage not only follows through on international commitments, but also provides an opportunity for authorities to reinforce the message that the two regulatory superpowers are still in step.

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