Tassos Repakis LLB Thesis

“THE IMPLEMENTATION OF ‘BASEL III’ INTO THE
LAW OF THE EUROPEAN UNION”
STUDENT AUTHOR
Anastasios Repakis
DISSERTATION SUPERVISOR
Dr. Federico Ferretti
This dissertation is submitted for the degree of LLB of Brunel University - 2013. This
dissertation is entirely my own work and all material from other sources, published or
unpublished, has been duly acknowledged and cited.
___________________________ ___________________
Student Date

Acknowledgements:
I would like to take this opportunity to thank the staff at Brunel University for their
advice and support, in particular my dissertation supervisor for his invaluable advice,
encouragement and guidance throughout my dissertation project. I would like to thank
my family for supporting me in the pursuit of my ambitions and the special people in
my life who inspire me to always look further.

Abstract:
The reasons behind the ongoing financial and economic crisis the world today
experiences have triggered a large scale regulatory reform, both on international and
European level. This dissertation will attempt to survey and assess the recent changes
which are promoted in the Law of the European Union in order to supplement the
deficiencies of the pre-existing regulation of the banking system. The main focus will
be on the implementation of the recent recommendations made by the Basel Committee
on Banking Supervision, widely known as ‘Basel III’, as an international response to the
consequences of deregulation which led to today’s financial crisis. Finally, it will also
consider the dissenting arguments on banking regulation, in general, but also on the
criticism that has been particularly laid on ‘Basel III’.
Information will be obtained through the research of Committee reports, the European
Union’s legislation proposals relating to the implementation of the Basel
recommendations, bibliography regarding banking regulation in general and, mostly,
other academic resources which are more updated in regards to the ongoing
developments surrounding the issue in hand, such as journal articles. Furthermore,
reference will be made to working papers of international organisations which analysed
the actual impact on the market.

Table of Contents
Acknowledgments
Abstract
1. Introduction 1
1.1 The significance of banks in modern economy 1
1.2 The consequences of an unhealthy banking system: Financial Crises 2
1.3 Regulation: a compelling necessity 3
1.4 The Basel Accords: a step towards international regulatory coherence 3
2. Historical Overview 5
2.1 The Basel Committee and its initial activity 5
2.2 The 1988 Basel Accord 9
2.3 ‘Basel II’ and the Capital Requirements Directive 11
3. ‘Basel III’ 18
3.1 The Crisis of 2009: a result of deregulation and its impact on European growth 18
3.2 Why the pre-crisis European legal framework failed 20
3.3 The ‘Basel III’ recommendations 23
3.4 Implementation into European law 28
3.4.1 ‘Capital Requirements Directive IV’ 29
3.4.2 ‘Capital Requirements Regulation’ 32
4. Criticism 36
4.1 Expectations and Assessment 36
4.2 How has the banking system responded to the news of tighter regulation so far? 38
4.3 Can regulation backfire? 39
5. Conclusive Commends 42
Table of Statutes
Bibliography

1
1. Introduction
1.1 The Significance of Banks in Modern Economy:
Despite the fact that the notion of banking is ancient, the first institution which in some
way resembled what we refer to as a ‘bank’ today was established in Venice
approximately seven centuries ago. It was a public corporation designated with the duty
to manage the repayment of a loan the Venetian government required in order to finance
its war efforts.1
Since then, banks have acquired an indispensable role in modern economy. One of the
most important functions that banks perform is that they provide with an efficient
channel through which savings are used to finance undertakings which lubricate the
wheels of economy and promote growth. In addition, by supervising the progress of the
activity they finance, banks act as delegated monitors and promote healthy investments.
Another aspect of banking which has proven very useful for the economy is the
diversification of risk. Through their interconnected nature banks are able to export
assets with concentrated risk and minimise danger.2
1
Richard Hildreth, The History of Banks: To Which Is Added, a Demonstration of the Advantages and
Necessity of Free Competition In the Business of Banking (Batoche Books 2001) 5
http://www.efm.bris.ac.uk/het/hildreth/bank.pdf accessed on 13 February 2013
2
Franklin Allen and Elena Carletti, ‘The Roles of Banks in Financial Systems’ (21 March 2008) 1,20
http://finance.wharton.upenn.edu/~allenf/download/Vita/Allen-Carletti-Oxford-Handbook-210308.pdf
accessed on 22 February 2013

2
1.2 Banks and Financial Crises:
The most basic affair of banking is the ability of investing the pooling capital from
customer deposits. Banks invest funds accumulated from savings and short-term
investments and invest them in long term assets. This activity allows banks to raise
more capital and impute interest to their customers in exchange for their deposits or
reinvest, therefore perpetuating the cycle of growth in economy. This process, however,
exposes banks to the possibility of depositors requiring their assets early, which leads to
what is referred to as a ‘run’. In such event banks are exposed and cannot fulfil their
obligations towards their customers. The situation outlined above is a superficial
description of a banking crisis and can be caused either by an event which shook the
confidence of customers towards the bank or due to misappropriation of the capital
which resulted to unsustainable losses.3
Despite the positive impact the globalised nature of today’s financial system has on the
apportionment of risk, it also allows a degree of interconnectedness which magnifies the
shock of a failure by spreading the contagion. This way, depending on the size of the
defaulting institution and its systemic significance, a banking crisis may rapidly evolve
to a financial crisis with the consequences everyone today experiences.
3
ibid 7

3
1.3 Regulation: a Compelling Necessity:
The need for regulation is commensurate with the significance of the banking sector in a
healthy economy. It is the vital significance of banking processes in today’s financial
system and economic structure which differentiates financial institutions from other
corporations and necessitates their protection through regulation. The term ‘regulation’
refers to a set of rules which governs the behaviour of institutions, enables designated
authorities to monitor the proper application of those rules and provides for the general
supervision of banks’ behaviour. Most commonly, regulation imposes specific standards
that need to be met and seeks to guarantee the existence of parameters which ensure the
viability of the institution, like capital reserves, liquidity and internal processes of risk
assessment. The task, however, is not an easy one and regulators face various
challenges. The increasing complexity in the nature of banking business, the speed of
transactions - which renders their effective supervision almost impossible - and the
implications of globalisation pose a serious challenge even to the most determined and
adequately informed regulatory body.4
1.4 The Basel Accords: a step towards international regulatory coherence:
The body which is committed to carry out the gigantic task of banking regulation on an
international level is the Basel Committee on Banking Supervision. The work of the
Basel Committee comprises of the adoption of certain standards which promote
4
Charles Goodhart, Philipp Hartmann, David Llewellyn, Liliana Rojas-Suarez and Steven Weisbrod,
Financial Regulation: Why, how, where and now? (Routledge 1998) Introduction

4
sufficient capitalisation of financial institutions and effective supervision of the
financial sector. The recommended framework which incorporates the above standards
is known as ‘The Basel Accords’ and constitutes the matrix against which the most
significant economies of the world shape their banking regulations.5
At first, the following chapters will describe the historical evolution of the Basel
Committee, its initial recommendations and their first implementations into national
laws. Subsequently, attention will shift to the Committee’s most recent framework
which came as an answer to the financial crisis - widely known as ‘Basel III’ - and its
implementation into the law of the European Union. Lastly, the closing chapters will
consider the criticism to which the latest framework has been subjected and outline the
system’s initial responses to the new requirements.
5
Joe Larson, ‘The Basel Capital Accords’ (April 2011) 8-9
http://ebook.law.uiowa.edu/ebook/sites/default/files/Basel%20Accords%20FAQ.pdf accessed on 10
February 2013

5
2. A Historical Overview
2.1 The Basel Committee and its Initial Activity
According to its Charter, the Basel Committee on Banking Supervision “is the primary
global standard-setter for the prudential regulation of banks and provides a forum for
cooperation on banking supervisory matters. Its mandate is to strengthen the regulation,
supervision and practices of banks worldwide with the purpose of enhancing financial
stability.”6
The Committee is consisted of the Governors of the central banks of the G-
10 countries who represent the world’s most influential financial centres.7
The above
purpose is pursued through the exchange of information, within not only its members
but also international bodies and organizations, relating to the functioning of the
banking sector and financial markets in different jurisdictions which would allow the
Committee to identify risks of systemic exposure and regulatory gaps. Furthermore, the
Committee is supervising the consistent implementation of its proposals so that the
same standards are raised in different jurisdictions. 8
Despite its strong influence in laying down international guidelines on banking
supervision, it is important to clarify that the Committee does not possess any formal
supranational authority, neither its recommendations have any binding legal effect on its
members. Through its procedures, general standards and guidelines are created which
6
Bank for International Settlements, ‘The Charter of the Basel Committee on Banking Supervision’
(January 2013) 1 (‘The Basel Committee Charter’)
7
According to the Bank of International Settlements website, the countries represented in the Committee
are Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India,
Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore,
South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.
http://www.bis.org/bcbs/about.htm accessed on 11 February 2013
8
‘The Basel Committee Charter’ (n 6) 1

6
point out to the right direction and promote regulatory coherence, although without
being followed by a mandate of compulsory implementation.9
The name of the Committee derives from the Swiss city of Basel, which is the base of
the Bank for International Settlements. The Bank of International Settlements hosts the
meetings of the Committee and provides with its permanent Secretariat.10
The
Committee meets four times a year, unless additional meetings are deemed necessary by
the Chairman, and it is the ultimate decision-making body, burdened with the
responsibility of ensuring that its mandate is achieved. The oversight of the Committee
lies with the Group of Governors and Heads of Supervision, also known as ‘GHOS’,
where the Committee will report, turn for direction and seek endorsement when a
decision is being made. The Chairman presides over Committee meetings and its
members are represented by appointed officials with the authority to commit the
institutions they act for. The Committee allocates and monitors its work by establishing
groups, work groups and task forces which are consisted of senior staff and technical
experts representing members of the Committee. The Chairman, besides chairing and
convening the Committee meetings, also monitors the progress of its activities, reports
to the GHOS and acts as the Committee’s representative. In addition, the Committee is
supported by a Secretariat, provided by the Bank of International Settlements. The
Secretariat is consisted of professional staff originating from the Committee’s members
and it is headed by a Secretary General. The Secretary General is appointed by the
Chairman and carries the duty of the Secretariat’s management.11
9
Basel Committee on Banking Supervision, ‘History of the Basel Committee and its Membership’ (Bank
for International Settlements, August 2009) 1
10
Peter E Ellinger, Eva Lomnicka and Christopher V M Hare, Ellinger’s Banking Law (5th edn, OUP
2011) 77
11
‘The Basel Committee Charter’ (n 6) 3 - 5

7
The establishment of the Basel Committee came in response to the collapse of
Bankhaus Herstatt, a banking institution of West Germany. It was concluded that the
failure of Herstatt was a direct result of lax banking supervision and lack of cooperation
between supervisory authorities. The Committee was established in December 1974 and
its first meeting took place in February 1975. Its initial concern was the adoption of a
number of principles that would allow the coherent supervision of banking institutions
with international activities. The Committee’s first recommendations were set out in the
Concordat of September 1975.12
The Concordat stressed the need of cooperation
between national authorities in order to ensure that no foreign banking establishment
escapes effective supervision. Furthermore, it laid down guidelines under which
supervisory responsibilities are divided between jurisdictions in relation to institutions’
liquidity, solvency and foreign exchange positions. Finally, in order to improve
cooperation amongst national authorities, the Concordat recommended the direct
exchange of information, the direct inspections of international establishments from the
authorities of the country where the parent institution is based and the indirect
inspections of international establishments with the local authority acting as an agent of
the parent authority.13
Despite it being a positive step towards a consistent international supervision of banking
activities, the 1975 Concordat failed to prevent the collapse of Banco Ambrosiano in
1983. This failure led to the review of the 1975 effort and to the Revised Concordat,
which was concluded in May 1983. The 1983 report incorporated the technique of
12
George Alexander Walker, International Banking Regulation: Law, Policy and Practice (Kluwer Law
International 2001) 85
13
Committee on Banking Regulation and Supervisory Practices, ‘Report to the Governors on the
Supervision of Banks’ Foreign Establishments’ (Bank for International Settlements, 25 September 1975)
(1975 Concordat) http://www.bis.org/publ/bcbs00a.pdf accessed on 15 February 2013

8
consolidation which was first recommended in March 1979 and allowed parent
authorities to examine an institution’s business by including in the same balance sheet
activities of its foreign establishments.14
In addition to consolidation, the Committee
suggested that parent authorities should discourage institutions from extending their
activities to jurisdictions where supervision is inadequate and - vice versa – that host
authorities should act in the same manner and forbid inadequately supervised
institutions from expanding their business in their jurisdiction.15
A final addition to the
Concordat came in April 1990, when the Committee issued a report underlying the
importance of information flows between parent and host supervisory authorities.
Therefore, in order to increase supervisory collaboration, the Committee recommended
that a consultation between the parent and the host authority should be part of the
authorisation process. Furthermore, it suggested that a reporting routine should be
established between the foreign establishment and the parent bank so that the parent
authority has continuous access to consolidated information. Finally, the 1990 report
recommends that the parent authority should make available to the host authority all the
information that would make the supervision of the foreign establishment more
effective - “on the basis of mutual trust”.16
14
Walker (n 12) 85
15
Basel Committee on Banking Supervision, ‘Principles for the Supervision of
Banks’ Foreign Establishments’ (Bank for International Settlements, May 1983) (Revised Concordat)
http://www.bis.org/publ/bcbsc312.pdf accessed on 15 February 2013
16
Basel Committee on Banking Supervision, ‘Information Flows Between
Banking Supervisory Authorities’ (Bank for International Settlements, April 1990)

9
2.2 The 1988 Basel Accord
Besides supervision, the Committee was also concerned by the continuously
deteriorating standards of capital adequacy. In order to control the growing risk
exposure and increase the stability of the banking sector on an international level, the
Committee considered the adoption of a regulatory framework which would require
risk-weighted assets to be balanced with a minimum ratio of capital. This led to the first
capital accord – known as the 1988 Capital Accord.17
The 1988 Accord was the result of
the widespread belief among the Committee members that regulatory convergence
would promote consistency, not only necessary for the soundness and stability of the
international banking system but also for the preservation of healthy competition
between international banking institutions.18
The Accord introduced a capital ratio which would measure the bank’s capital against
its exposure to risk-weighted assets. Under the new regime, an institution must have a
minimum capital ratio of 8% to be sufficiently capitalised. A key factor, however, in
assessing the capital adequacy of a bank is the quality of its capital. The Committee
decided that assessment of capital should be made in comparison to its ability to absorb
asset losses.19
Therefore, it established a two-tier division when defining capital. The
first tier consists of core capital (basic equity) which is common to every banking
system; it is a common variable for measuring capital adequacy, easily ascertainable
and has a crucial role in the institution’s profitability. The second tier capital is
considered less reliable and comprises of loan-loss and other reserves, subordinated
17
‘History of the Basel Committee and its Membership’ (n 9) 2
18
Basel Committee on Banking Supervision, International Convergence of Capital Measurements and
Capital Standards (BIS July 1988, updated to April 1998) 1 (The Basel Accord)
19
Joe Larson, ‘The Basel Capital Accords’ (April 2011) 8-9
February 2013

10
debt, deductions from capital and hybrid debt capital instruments. Underlining the
quality difference between the two tiers, the Committee suggested that the adopted
recommendations should be implemented in a way requiring at least 50% of the
institution’s capital to be consisted of core capital.20
The above distinction reflects the
Committee’s understanding that adequacy is a matter of quality – not quantity –and
capital requirements need to counterweight, not the number of the institution’s assets
but their exposure to risk.21
Similarly, the Committee adopted a multi-category qualitative division of risk-weighted
assets, based on the risk attached to them like credit-risk and the counterparty’s
probability of failure. Five classes of “weights” were created (0, 10, 20, 50 and 100%)
and each class added a different percentage of the value of the asset to the institution’s
overall exposure to risk. For example, assets like claims on central governments and
domestic public-sector entities fell under the first category and added 0% of their value
to the institution’s exposure because they were considered of low-risk. Riskier
activities, however, like loans secured by mortgage on residential property, add 50% of
the asset’s value and claims on the private sector add 100%.22
Finally, a significant contribution of the 1988 Accord was the inclusion of off-balance
sheet assets to the measurement of risk exposure by converting them to credit-risk
equivalents. Off-balance sheet activities are usually promises of credit, like an open line
of credit made available to a customers or a standby letter of credit which ensures
customers’ debts towards third parties will be covered by the institution in the event of
default. The Committee acknowledged the importance off-balance activities would have
20
The Basel Accord (n 13) 3 - 4
21
Larson (n 19) 10
22
The Basel Accord (n 18) 7-13

11
on the realistic measurement of risk and under the 1988 framework assets arising from
such activity are considered credit-risk equivalents.23
The recommended framework under the 1988 Accord was widely implemented and for
the first time a common framework on capital adequacy standards was created. Initially,
the new framework promoted market discipline and motivated undercapitalised
institutions to make the necessary adjustments and achieve the expected adequacy
ratios. In time, however, banks adapted to the new environment and learned how to
manoeuvre around the limitations the 1988 framework established. Banks developed
new techniques, like securitisation, which unveiled the broad nature of the 1988 capital
requirements and allowed banks to engage into capital arbitrage and artificially appear
adequately capitalised. Moreover, in their effort to achieve better ratios, banks found the
removal of risk-weighted assets from their balance sheets to be more efficient than
increasing their capital. The theory that a strict regime of capital requirements can lead
to credit crunches and affect real economy was partially affirmed by the consequences
lending reduction had to the US real estate sector after the first years of
implementation.24
2.3 ‘Basel II’ and the Capital Requirements Directive
The 1988 Accord was heavily criticised on the basis that it failed to provide a viable
solution to systemic risk exposure and the Committee decided that reform was on its
way. The proposed reform resulted to the release of a New Capital Framework in 2004
23
ibid 12
24
Patricia Jackson, ‘Capital Requirements and Bank Behaviour: the Impact of the Basle Accord’ (Bank
for International Settlements 1999) Basle Committee on Banking Supervision Working Paper 1/1999, 1-
5, 29 http://www.bis.org/publ/bcbs_wp1.pdf accessed 12 February 2013

12
after a five-year process of negotiations and consultations. The main objective of the
revised framework – known as ‘Basel II’ – was to create more risk-sensitive capital
requirements and not to change the level of capital banks need to hold as established in
the first accord. In addition, the revised framework sought to encourage the internal
assessment of risk and allocation of capital, in accordance to certain minimum
requirements which would guarantee the integrity of those internal procedures.25
In order to secure international convergence and provide with an integrated solution to
systemic risk exposure, the Committee adopted a common accord consisted of three
pillars: minimum capital requirements, which provide with an expanded and more
detailed framework than the first accord; supervisory review and assessment process,
which ensures coherent implementation of the adopted rules and better international
coordination amongst supervisory authorities; and disclosure requirements, which
promotes transparency and market discipline.26
The first pillar of ‘Basel II’ proposed two sophisticated approaches of risk assessment
that would give a realistic image of risk exposure and prevent banks from relying to
financial innovation in order to masquerade the risk inherent in their assets. The first
approach is the Standardized Approach and it has a similar way of assessing the weight
of risk attached on assets as the first accord. In addition to the five classes of ‘weights’
of the first framework - which carried 0, 10, 20, 50 and 100% of the asset’s value in the
calculation of the institution’s total risk exposure – the Standardized approach added
another two of 35 and 150%. A significant addition of the Standardized approach is that
25
Rosa Maria Lastra, ‘Risk-based Capital Requirements and their Impact upon the Banking Industry:
Basel II and CAD III’ (2004) JFRC 225 at 230; Larson (n 19) 14-15
26
Basel Committee on Banking Supervision, International Convergence of Capital Measurement and
Capital Standards: A Revised Framework (BIS, June 2004) 4-5 (Basel II); ‘History of the Basel
Committee and its Membership’ (n 9) 3

13
the categorization of the asset would not be dependent on the generic identity of the
counterparty but on the credit rating the counterparty received by independent rating
agencies. The only exceptions would be non-rated assets which would fall automatically
to the ‘100%’ class and loans secured by mortgage on residential properties which fall
within the ‘35%’ class regardless of the counterparty’s rating.27
The second approach is the Internal Ratings-Based Approach and allowed - subject to
supervisory approval, certain minimum conditions and disclosure requirements - banks
to rely on internal procedures for the assessment of credit risk and the estimation of
‘adequate’ capital. Central to the application of the IRB approach is the notions of
institutions’ expected and unexpected losses. Losses characterized as ‘expected’ are
those which do not exceed the historical average of losses and allow banks to rely on
statistic data in order to calculate the necessary reserves that need to be made. However,
losses that exceed historical averages present a serious exposure to risk since they are
not foreseeable and banks may not be sufficiently capitalised to absorb them. In
predicting the severity of unexpected losses and calculating the resulting exposure, the
Internal Ratings-Based approaches base their estimation on certain components. The
first component is the ‘probability of default’ and it measures the counterparty’s ability
to meet its obligations and how probable the event of default may be. Another
component is ‘loss given default’ and provides with the net losses of the institution in
the event of the counterparty’s default. A third component is the ‘exposure at default’
and reflects on the additional losses a bank may sustain by other engagements with the
defaulting counterparty and – finally - the last component is ‘effective maturity’, which
estimates exposure based on the duration of the loan and the flow of repayments. The
27
Basel II (n 26) 15-22

14
above components are the key variables of the formula which banks will deploy when
following the IRB approach in calculating credit risk. Lastly, dependent on who
estimates the value of those components, IRB approach is divided in two sub-
categories: the Foundation IRB Approach and the Advanced IRB Approach. In
Foundation IRB the institution and supervising authorities estimate the value of the
above components jointly, whereas in Advanced IRB the institution is solely
responsible for that.28
It was, however, in the view of the Committee that capital adequacy requirements are
not in themselves sufficient to address the problem of systemic risk exposure.
Therefore, ‘Basel II’ included a second pillar which regulated the supervisory process of
capital adequacy upon principles that would encourage self-assessment but at the same
time would strengthen supervision. The Committee believed that banks should have an
internal process for assessing their overall capital adequacy in relation to their risk
profile and a strategy for maintaining their capital levels. In subsequence, this process
should be reviewed by supervisory authorities, as well as institutions’ ability to monitor
and ensure their compliance with regulatory capital ratios. In case the outcome of this
process was unsatisfactory, the second pillar enabled authorities to take appropriate
supervisory action where necessary. Even further, banks could be required to operate
above the minimum regulatory capital ratios and to hold capital in excess of the
minimum as ‘buffers’ against adverse market conditions when supervisory authorities
considered it necessary. Finally, under the second pillar, authorities could take pre-
emptive action if they become concerned that an institution fails to meet the adequacy
requirements. Such action could vary from simply intensifying supervision to requiring
28
Basel II (n 26) 48; Larson (n 19) 18-20

15
the bank to raise additional capital immediately and improve internal risk assessment
systems and controls.29
As a supplement of the first two pillars, the Committee incorporated into the ‘Basel II’
framework a third pillar which regulated market discipline through disclosure
requirements. The measure of disclosure sought to increase transparency by making
available to market participants information relating to the banks’ capital adequacy, risk
exposure and internal processes of risk assessment.30
Despite its detailed nature and the Committee’s influence on the financial world, the
‘Basel II’ three-pillar framework is considered as ‘soft law’ due to its non-binding
nature. The impact of ‘Basel II’ was significantly enhanced by its implementation into
the law of the European Union in 2005. The European officials incorporated the Basel
recommendations into two pieces of legislation, which together form what is being
referred as the ‘Capital Requirements Directive’. The first part of the CRD is Directive
2006/48/EC relating to the taking up and the pursuit of the business of credit
institutions. The second part is Directive 2006/49/EC on the capital adequacy of
investment firms and credit institutions. All institutions under the umbrella of the CRD
had to implement it by 1 January 2008. The purpose behind this legislative initiative
was the promotion of supervision and capital requirements convergence within the
Union by closing the gaps between the different national practices. Because of the
Union’s diverse nature, the Committees supervising the implementation of the CRD in
national law allowed a certain degree of flexibility to Member States but, as time
passed, consistent implementation was encouraged through the introduction of more
29
Basel II (n 21) 158 - 165
30
ibid 175

16
country-neutral approaches. Moreover, certain changes were introduced to the adopted
framework, which the officials in Brussels thought would better accommodate the needs
of the Union.31
In addition to the aforementioned difference on the binding effect of their provisions,
there are other areas where ‘Basel II’ and the CRD lack resemblance. A major
difference lies in the scope of their application since ‘Basel II’ was devised to regulate
the activity of large and internationally active banks, whereas the CRD applies to all
credit institutions. Additionally, the two regimes treat financial activities differently
when it comes to assessing the percentage of risk they add to the total exposure of the
institution. For example, when it comes to pillar one and capital requirements certain
financial products, like the highly-rated German bank debentures called ‘Pfandbriefe’ or
claims on High Volatility Commercial Real Estate, receive different risk evaluation
under the two frameworks. Likewise, noticeable differences have been detected in the
implementation of pillars two and three, like variations on the intensity of supervisory
reviews and the frequency of disclosure.32
In assessing the regulatory contribution of the Basel Committee through its
recommendations, one cannot fail to notice that each initiative was triggered from a
collapse of an institution or an event that exposed the financial system to substantial
risk. In addition, one also cannot fail to notice that each attempt did not prevent such
exposures from reoccurring. A significant conjuncture in the implementation processes
of ‘Basel II’ and the CRD was the outbreak of the global financial crisis of 2008,
because of which the weakness of the newly adopted framework were highlighted rather
31
Rym Ayadi, Basel II Implementation in the Midst of Turbulence (Centre for European Policy Studies
2008) 62-73; Ellinger’s Banking Law (n 10) 77; Lastra (n 25) 236;
32
Ayadi (n 31) 126-130

17
quickly and another regulatory initiative was triggered which resulted to – what is now
referred to as – ‘Basel III’. The following chapter will address the issues of the pre-2008
framework which allowed the crisis to become systemic and rendered the adoption of
further regulation a compelling necessity. Subsequently, it will outline the
recommendations adopted in ‘Basel III’, the degree of their implementation into EU law
and the results this implementation is expected to bring.

18
3. ‘Basel III’
3.1 The Crisis of 2009: a Result of Deregulation and its Impact on European
Growth
More than four years have passed from the collapse of Lehman Brothers33
and the
world’s economy is still struggling to recover from the consequences of the global
financial crisis of 2009. But before analysing how deregulation has resulted to the
exposure of global economy, some reference has to be made to the actual events that
destabilised the market.
The root of the problem can be found in the approach that the US government adopted
towards banking regulation in the ‘80s that “less is more”. This lenient approach
allowed banks to come up with complex financial innovations which allowed increased
profitability but at the same time carried equal amounts of risk. In addition, under this
regime of leniency, banks became more and more intertwined, rendering proper
supervision and regulation impossible without impeding growth. An important factor in
the adoption of this policy was the huge demand for liquidity. An example is the huge
rise in the demand for homeownership. The concept was that lax supervision and less
regulation would allow the banking sector to adopt techniques – like securitisation –
which would help them accommodate the increasing demand for homeownership in the
market. However, huge demand caused prices to soar and, since no regulation was in
place to prevent it, a bubble in the US real estate market was created. When the demand
was eventually satisfied and prices dropped, the value of most mortgaged properties was
33
September 2008

19
not enough to cover value of the loan for their purchase. As a result, the value of
mortgaged-backed securities plummeted and institutions which owned such assets – like
Lehman Brothers - were exposed.34
At the same time, the supervisory and regulatory regime that was put in place was
insufficient in preventing the consequences of Lehman’s failure from spreading to the
rest of the financial system. As a consequence of Lehman’s failure, liquidity evaporated
when the risk management tools put forward by ‘Basel II’ required banks to increase the
collateralisation of their down-graded securities. The lack of liquidity spread throughout
the banking system, stretching banks to their limits. The liquidity shortages choked the
market and caused the whole economy to shrink. Thus, the crisis evolved from
‘systemic’ to ‘economic’ and due to the globalised nature of today’s financial system
contagion spread throughout the world leaving none unaffected.35
In Europe the impact of the crisis was inevitable due to the close commercial connection
between the European Union and the United States. The same approach which
promoted transatlantic conformity in the nature of banking business also allowed the
crisis to spread instantly and led to the contraction of the Union’s financial indicators.
Both the European Union and the Eurozone experienced severe recession in 2009.
Moreover, unemployment rose and inflation decelerated. Additionally, and despite the
34
Éric Tymoigne, ‘Securitization, Deregulation, Economic Stability, and
Financial Crisis, Part II: Deregulation, the Financial Crisis, and Policy Implications’ (August 2009) The
Levy Economics Institute Working Paper 573.2/2009, 1-3
http://www.levyinstitute.org/pubs/wp_573_2.pdf accessed 16 February 2013
35
‘Report of High-level Expert Group on Reforming the Structure of the EU
Banking Sector’ (HLEG October 2012) 4-8 http://ec.europa.eu/internal_market/bank/docs/high-
level_expert_group/liikanen-report/final_report_en.pdf accessed 15 October 2013 (Liikanen report)

20
contraction of Europe’s gross domestic product, its budget deficit almost doubled within
a year.36
Of particular interest is, however, the impact of the crisis on European Union’s
integration. Since the Treaty of Rome and the establishment of the European Economic
Community, progress in the project of integration has been slow but steady. Especially
when it came to economic integration, the commitment to pursue a common trade
policy led initially to the Single European Market and more recently to the adoption of
common currency between the Union’s core countries. Although progress in economic
integration is rather noticeable, the same thing cannot be said for the advancement of
integration in the political sphere, therefore creating certain asymmetries in policy
implementation between Member States. Those asymmetries became more apparent in
the turmoil of the crisis. The crisis nurtured euroscepticism and national policies
attempting to halt contagion fed the threat of introversion.37
3.2 Why the pre-Crisis Legal Framework Failed:
Even before the implementation of ‘Basel II’ and the occurrence of the financial crisis,
theorists identified the flaws of the recommended framework which failed to prevent the
economic decline the world faces today. One of the main issues of the ‘Basel II’
framework was the procyclical effect that capital requirements brought to the market.
36
Dennis J. Snower, ‘The Impact of the Global Financial Crisis on Europe and Europe's Responses’
(AEEF Conference, Kiel, July 2009) 2-3
http://www.bruegel.org/fileadmin/bruegel_files/Research_contributions/AEEF_contributions/Crisis_Deve
lopments_and_Long-Term_Global_Response/AEEF4PPDenisJ.Snower.pdf accessed on 16 February
2013
37
Marek Dabrowski, ‘The Global Financial Crisis: Lessons for European Integration’ (2009) CASE
Working Paper 384/2009, 13-15 http://www.case-
research.eu/upload/publikacja_plik/24767837_CNS&A384_April14_final.pdf accessed on 19 February
2013

21
The term ‘procyclical’ refers to the intensification of financial fluctuations and
economic volatility. It was foreseen that if institutions had to hold more capital in order
to satisfy the requirements laid down by ‘Basel II’ access to liquidity would be limited,
therefore aggravating the consequences of a looming credit crunch. In addition to
procyclicality, target of criticism was the way ‘Basel II’ treated securitisation. Until the
crisis, the Committee treated asset securitisation as an efficient way to diversify risk by
redistributing it among different banking or non-banking institutions. However, the
same characteristics of securitisation which allow risk diversification also permitted
contagion to spread. Furthermore, the degree of discretion and flexibility given to banks
by the risk management tools adopted in ‘Basel II’ allowed them to use securitisation in
order to achieve regulatory arbitrage and hide the true risks inherent in their portfolios.
Thirdly, attention was drawn on the significant role rating agencies were called to play
under ‘Basel II’. Despite the heavy reliance based on them in the assessment of risk
weights, regulation and accountability of rating agencies did not correspond with their
significance. Without carrying any official status, opinions of rating agencies were
promoted from mere tools for differentiating credit quality to the highest authority in
measuring risk exposure. What is more, the fact that rating agencies receive
remuneration from the companies they assess may raise reasonable suspicion over their
impartiality. Finally, ‘Basel II’ was criticised over its consequences on competition in
financial services, since it applied only to banks leaving outside non-banking
institutions which may undertake some banking activities. In addition, the complexity of
its rules puts smaller banks in the tougher position and favours bigger institutions.

22
Lastly, the implementation of ‘Basel II’ has not progressed uniformly since different
jurisdictions – like USA and Europe - appraised it differently.38
Particularly in Europe, the procyclical character of ‘Basel II’ was introduced by the
Capital Requirements Directive. Furthermore, the diverse nature of the European Union
and degree of political integration achieved, prevented the regime’s full adoption and
justified some variations which would accommodate the Union’s distinguished
idiosyncrasy. This, however, resulted to regulatory gaps and supervisory inconsistencies
which undermined the effectiveness of the regime. In the aftermath of the crisis, it was
noticed that supervision focused more on the stability of certain components of EU’s
financial system (micro-prudential supervision), rather than addressing systemic risk en
masse (macro-prudential supervision). It was also noticed that the early risk warning
mechanisms put in place with CRD failed when at same time the transitional periods
and implementation processes of the Directive promoted uncertainty and undermined
any prospects of supervisory cooperation among national authorities.39
An important lesson from the financial crisis has been the impact of legal diversification
in a globalised system where international dependencies and externalities are constantly
on the rise. The systemic effects of incoherency in regulating financial processes of a
globalised economy have underlined the need for legal certainty through the
enhancement of supervisory cooperation and the safeguarding of competition. Gaps in
international supervision, along with financial innovations adopted by banks to achieve
38
Rosa Maria Lastra, ‘Risk-based Capital Requirements and their Impact upon the Banking Industry:
Basel II and CAD III’ (2004) JFRC 225 at 234 - 235
39
Marianne Ojo, ‘Basel II and the Capital Requirements Directive: Responding to the 2008/09 Financial
Crisis’ (September 2009) 3-5 http://ssrn.com/abstract=1475189 accessed on 20 February 2013

23
regulatory arbitrage, exposed the ‘Basel II’ regime to a level which necessitated
amendments.40
3.3 The ‘Basel III’ Recommendations:
In order to put a halt to the momentum of the crisis and prevent the world from sinking
into depression, banks had to be recapitalised and access to liquidity restored.
Therefore, in considering the necessary amendments of the existing regulatory and
supervisory framework, the G20’s main focus was to ensure that governments would
never again have to bail out the sector. The Committee sought to remove any
assumption that banks may resort to taxpayers’ money to avoid failure and prevent
governments’ from facing again the dilemma of either bailing out a systemic institution
or exposing the whole economy to danger (what became known as “moral hazard”).41
According to Jaime Caruana – the General Manager of the Bank for International
Settlement - in achieving the above the new framework aim s to increase the level and
quality of capital, reduce systemic risk and allow sufficient time for a smooth transition
to the new regime by extending its implementation timeframe to 2019.42
In regards to the quality of the capital held by banks, ‘Basel III’ provided with a new
definition of regulatory capital, which is more restrictive and prevents inconsistencies
between jurisdictions. The composition of tier 1 capital becomes stricter and it is limited
only to equity stock and retained earnings. Simultaneously, the percentage of tier 1
40
Helmut Wagner, ‘Is Harmonization of Legal Rules an Appropriate Target?: Lessons from the Global
Financial Crisis’ [2012] EJL & E 541 at 552-554
41
Richard Barfield, Sonja Du Plessis, Patrick Fell, ‘Basel III: Implications for Risk Management and
Supervision’ [2011] COB 1 at 1-2
42
Jaime Caruana, ‘Basel III: Towards a Safer Financial System’ (3rd Santander International Banking
Conference Madrid, 15 September 2010) 2

24
capital has increased from 4 to 6% of the bank’s risk-weighted assets. In the same
direction, the Committee sought to increase the quantity of the capital held by banks. In
addition to the already existing capital ratio of 8%, the new regime introduces a capital
conservation buffer equal to at least 2.5% of the institutions risk-weighted assets, salted
away through the reduction of discretionary distributions of earnings.43
One of the lessons from the financial crisis was the implications of excessive leverage
on the banking system. Despite being adequately capitalised under ‘Basel II’, during the
crisis highly leveraged banks had to undertake deleveraging processes which negatively
affected the availability of capital and, subsequently, liquidity. Therefore, ‘Basel III’
introduces a leverage ratio of 3%, which requires banks to reserve capital equal to 3% of
its total assets. It is important to notice that the new leverage ratio is introduced
irrespective from the bank’s coverage against risk since its calculation is made in
comparison, not only to its risk-weighted portfolio but to its total assets. It is, therefore,
a “backstop” measure which adds up to the risk-based capital requirements by limiting
the ability of banks to maneuver around their capital adequacy obligations. The
Committee also believes that with its introduction the stability of the financial system
will be protected from the destabilising consequences a future crisis may have on an
excessively leveraged banking system.44
To further enhance financial stability in stressed periods, ‘Basel III’ sought to eradicate
the aforementioned element of procyclicality which characterised the previously
adopted framework. To that end, the Committee re-examined capital requirements
43
Basel Committee on Banking Supervision, Basel III: A Global Regulatory Framework for More
Resilient Banks and Banking Systems (BIS December 2010, rev June 2011) 12-13, 54-56 (‘Basel III’ on
capital)
44
ibid 61

25
bearing in mind the relationship between banks and real economy and devised a
countercyclical buffer which would prevent the system from re-entering into a vicious
circle where economy is suffering from illiquidity which in return decapitalises the
banking sector and perpetuates the problem. The countercyclical buffer is implemented
as an extension of the capital conservation buffer mentioned above and it will range
between 0 and 2.5% of the institution’s risk-weighted assets. According to the new
framework, the actual percentage is left to be decided by national authorities and in
proportionality with the availability of credit in the economy. In simple words, the
concept of the countercyclical buffer introduces an additional requirement in periods of
low risk and credit growth which would guarantee liquidity in the event of a future
crisis by preventing banks from adopting drastic measures of capital conservation.45
However, the financial crisis taught regulators that capital requirements are not enough
in themselves to limit systemic risk exposure and highlighted the inability of the
previous framework to capture all material risks on and off the balance sheet. Thus, the
new regime refrained from just imposing higher capital requirements horizontally. On
the contrary, it recommends measures which promote the centralisation of derivative
transactions, create incentives for following more efficiently supervised processes (such
as moving OTC derivative contracts to central counterparties) and raises counterparty
credit risk management standards. Finally, in limiting systemic exposure ‘Basel III’
decreases the reliance of the previous framework to external rating agencies. Under the
new regulation, institutions have to perform their own assessments to externally rated
assets and adopt practices which prevent the procyclical implications of external ratings
45
ibid 57-60; Joe Larson, ‘The Basel Capital Accords’ (April 2011) 25-26
February 2013

26
oligopoly. Furthermore, the new regime strengthens the eligibility criteria for qualifying
as an external credit assessment institution.46
In addition to securing that the banking sector has access to adequate quantity and
substantial quality of capital, ‘Basel III’ recommended measures for promoting sound
liquidity risk management. An introduction by ‘Basel III’ which aspires to enhance the
shock-absorbing capacity of banks is the liquidity coverage ratio (LCR). Through this
new requirement the Committee wishes to ensure that in periods of financial and
economic stress, institutions will have access to adequate liquidity for 30 calendar days.
Banks must hold a number of unencumbered high quality liquid assets (HQLA) which
can be converted to cash in private markets quickly and without losses in order to
enable banks to survive a 30-day stress scenario. The new framework provides with
detailed characteristics of which assets would be accepted as ‘high quality’ and divides
them into two categories. Assets which fall within the first category can cover an
unlimited share of the total stock and they cannot be subjected to a haircut. Those
include coins and banknotes, central bank reserves and marketable securities which
carry no risk and satisfy very strict conditions. On the contrary, assets falling within the
second category are limited to 40% of the total stock after they have been subjected to a
15% haircut and may comprise of highly reliable corporate debt securities or marketed
securities which under ‘Basel II’ would carry only 20% of their value to the total
amount of risk-weighted assets. Lastly, it is in the discretion of national authorities to
include to the second category securities which can be subjected to bigger haircuts.
46
‘Basel III’ on capital (n 43) 3-4

27
However, this discretionary addition cannot cover more than the 15% of the overall
stock.47
To supplement the short term effect the liquidity coverage ratio, the Committee adopted
another metric in order to promote the medium and long-term liquidity. The new tool is
called net stable funding ratio (NSFR) and requires institutions to ensure their
accessibility to stable funding sources, sufficient to cover the liquidity needs of the bank
for a year.48
A final addition of ‘Basel III’ is a number of monitoring tools which enable supervisory
authorities to better assess the sound liquidity of the banking sector. According to the
new framework, conclusion over liquidity will be drawn in relation to five different
parameters. Firstly, authorities will compare the contractual inflows and outflows of
liquidity within defined time periods and depending on their findings they will draw the
institution’s contractual maturity mismatch profile. This parameter enables supervisory
authorities to measure the institution’s reliance on maturity transformation under its
current contracts. A second parameter is the concentration of funding, under which
authorities have to identify the sources of wholesale funding which would cause
liquidity problems to the institution in the event of withdrawal. The utilization of this
parameter gives an image, although not detailed, of the institution’s behavioural
tendencies in relation to the way it pursuits funding. Thirdly, an aspect supervisors
should take into consideration is the number and details of the institution’s
unencumbered assets. This information can provide authorities with a view over the
47
Basel Committee on Banking Supervision, Basel III: The Liquidity Coverage Ratio and Liquidity Risk
Monitoring Tools (BIS January 2013) 6-7, 11-15 (‘Basel III’ on liquidity)
48
Basel Committee on Banking Supervision, Basel III: International Framework for Liquidity Risk
Measurement, Standards and Monitoring (BIS December 2010) 25

28
bank’s potential to add more HQLAs to the LCR’s numerator. A fourth parameter
which under the new regime supervisory authorities have to take into consideration is
the calculation of the institution’s LCR by significant currencies. This parameter allows
banks and supervisors to track potential currency mismatch issues which could have
unforeseen implications in a period of stress. Finally, a last parameter which would
enable supervisory authorities to efficiently monitor the soundness of liquidity of the
banking sector is the process of market-related information. A closer look to the market
may reveal behaviours and reactions which indicate liquidity issues.49
3.4 Implementation into European Law:
The outbreak of the crisis in 2008 made evident that the revision of the ‘Basel II’
framework was on its way. The initial reaction from the Committee was to introduce
rules which limit regulatory arbitrage through securitisation and closely regulates
internal governance and staff compensation. Within the EU those first reactions were
incorporated with the introduction in 2009 of several pieces of legislation which came
to cover the gaps of the first CRD and became known as ‘CRD II’50
and ‘CRD III’51
.
The revision process that took place in Basel and Brussels was parallel. Almost
simultaneously with the publication of the ‘Basel III’ consultation results, the European
49
‘Basel III’ on liquidity (n 47) 40-47
50
Directive 2009/111
51
Commission Directive 2009/27; Commission Directive 2009/83 and Directive 2010/76

29
Commission published the consultation which resulted to the ongoing legislative
activity which implements ‘Basel III’ into EU law.52
The ‘Basel III’ framework is going to be implemented into EU law with the
introduction of a directive - known as ‘Capital Requirements Directive IV’53
– and a
regulation – known as ‘Capital Requirements Regulation’54
, both of which are expected
to change the current legislation in its entirety. As mentioned above, the implementation
process is still ongoing and changes still take place, therefore this research will limit its
ambit to the progress made up to January 2013 which was the initial deadline for the
implementation of ‘Basel III’.
3.4.1 ‘Capital Requirements Directive IV’
Although the legislative documents had not been finalised in detail up to January 2013,
the broader changes the new directive will introduce have been made available to the
public. Furthering the amendments made with ‘CRD II’ and ‘CRD III’, the new
Directive replaces Directive 2006/48 which was one of the two pieces of legislation that
implemented ‘Basel II’.
52
Bart P.M. Joosen, ‘Further Changes to the Capital Requirements Directive: CRD IV – Major Overhaul
of the Current European CRD legislation to Adopt the Basel III Accord: (Part 1)’ [2012] JIBLR 45 at 45-
46
53
Commission, ‘Proposal for a Directive of the European Parliament and of the Council on the Access to
the Activity of Credit Institutions and the Prudential Supervision of Credit Institutions and Investment
Firms and Amending Directive 2002/87 of the European Parliament and of the Council on the
Supplementary Supervision of Credit Institutions, Insurance Undertakings and Investment Firms in a
Financial Conglomerate (Capital Requirements Directive IV)’ COM(2011) 453 final
54
Commission, ‘Proposal for a Regulation of the European Parliament and of the Council on Prudential
Requirements for Credit Institutions and Investment Firms (Capital Requirements Regulation)’
COM(2011) 452 final

30
By comparing the new Directive to its predecessor, one quickly understands the depth
of the reform from significant amount of introductions which have been implemented.
In general, the new directive extends its scope to investment firms along with credit
institutions; strengthens prudential supervision by promoting cooperation between
supervisory authorities; creates a coherent sanctioning regime for institutions which fail
to comply with the new framework; introduces further changes to corporate governance
by promoting sustainable and responsible policies and implements the new capital
requirements recommended by ‘Basel III’.55
In regards to supervision, the new Directive requires Member States to designate
specific authorities which would monitor the proper application of the new framework
within their jurisdiction.56
In addition, it introduces the European Banking Authority
with a central role in monitoring the activities of the banking sector, therefore
promoting regulatory and supervisory convergence.57
Finally, in promoting supervisory
cooperation the new directive provides a more detailed outline of cooperation between
the supervisory authorities of Member States, not only regarding the functioning of
credit institutions and investment firms but financial stability in general.58
The new
Directive requires the establishment of an information channel between Member States
through which supervisory authorities will be able to exchange information regarding
capital adequacy and liquidity ratios of institutions which hold branches in more than
one Member State.59
Finally, the new Directive enhanced the ability of authorities to
conduct effective supervision by enabling them to impose sanctions to institutions
55
Joosen (n 52) 46-47; Graeme Baber, ‘Basel III implementation and the European Union: the proposed
Capital Requirements Directive (CRD IV)’ [2012] Company Lawyer 341 at 342,348-349,353
56
COM(2011) 453 final, CRD IV Art 5(2)
57
Baber ‘CRD IV’ (n 55) 343
58
COM(2011) 453 final, CRD IV Art 52(1)
59
ibid Art 51(2)

31
which fail to comply with the new regime. Sanctions may include the imposition of
specific disclosure requirements, restrictions in profit distribution – even withdrawal of
authorisation.60
Equally important is the contribution of the new directive towards the regulation of
corporate governance and effective risk management. The new regime promotes
internal risk assessment procedures in an attempt to limit overreliance to credit rating
agencies.61
To achieve this, institutions have to conduct periodical reviews of their risk
management processes and risk-weighted assets and adopt policies and procedures
which would identify any risk of excessive leverage. In addition, the new Directive
requires each significant institution to establish a risk committee which would have an
advisory role to the institutions strategy towards risk.62
In relation with capital requirements, the ‘CRD IV’ incorporates into EU law the capital
conservation and countercyclical buffers as recommended by ‘Basel III’. There is,
however, a differentiation in their implementation.63
The directive leaves authorities
with the discretion to relieve investment firms of low significance to financial stability
from the obligation to hold such reserves.64
Lastly, another possible derogation from
‘Basel III’ in relation to capital buffers is the adoption of a discretionary systemic risk
buffer to supplement the buffers included in ‘Basel III’.65
60
ibid Art 18, 99-102
61
Joosen (n 52) 46
62
COM(2011) 453 final CRD IV Art 75(3)
63
ibid Art 123, 124
64
Baber ‘CRD IV’ (n 55) 354
65
ibid

32
3.4.2 ‘Capital Requirements Regulation’
The second piece of EU legislation implementing the ‘Basel III’ recommendations is
the Capital Requirements Regulation. In supplement to new Directive, the Regulation
implements the new framework regarding the definition of capital, conservation against
unforeseen counterparty credit risk, safeguarding of liquidity and monitoring of
excessive leverage.66
The CRR implements fully the ‘Basel III’ conditions under which assets may be
considered as ‘tier 1’ capital, in order to ensure that only the highest quality instruments
would be recognised as the highest quality form of regulatory capital. Such instruments
are usually limited to ordinary shares of the institution. Additionally, in order to
promote legal certainty, the new framework imposed to the European Banking
Authority the duty to publish a list of instruments which satisfy the aforementioned
criteria.67
Furthermore, the Regulation treated similarly the position of ‘Basel III’ over the
mitigation of unforeseen counterparty credit risk by introducing a capital charge. In
order to mitigate counterparty credit risk, the new regime requires institutions to
establish a management framework which would lay down policies and processes under
which such risks will be identified and measured.68
Moreover, the new Regulation also
includes detailed methods for calculating the value of such risk exposure.69
Another part of the ‘Basel III’ framework addressed by the CRR is liquidity. Part 6 of
the Regulation includes provisions dealing with liquidity coverage of institutions and
66
COM(2011) 452 final 11, 13-14
67
ibid ‘CRR’ Art 24, 25(2), 26
68
ibid ‘CRR’ Art 280
69
ibid ‘CRR’ Art 269 – 278 (Sections 3-6)

33
the obligation of disclosure. In regards to liquidity coverage ratio, the CRR provides
that institutions must hold at all times a number of high quality liquid assets, the value
of which would suffice to cover the short-term liquidity needs of the institution in
stressed periods where access to liquidity is limited.70
The CRR includes provisions
which estimate the value of liquid assets and measure the volume of liquidity outflows
in order to calculate the liquidity coverage ratio.71
In addition, under both normal and
stressed circumstances, institutions expected to have taken positive action to ensure that
their long-term funding requirements are sufficiently met with a variety of stable
funding instruments, in correspondence with the ‘net stable funding ratio’ adopted by
‘Basel III’.72
Likewise, the Regulation requires institutions to report to supervisory
authorities the liquid assets they possess so authorities can draw a detailed picture of the
institution’s liquidity risk73
and describes which conditions have to be met for an asset
to be reported as a ‘liquid asset’74
.
Finally, the CRR introduces to EU law the leverage ratio, as a regulatory tool which
would further enhance institutions’ ability to absorb shocks in demanding periods. The
Regulation – like ‘Basel III’, leaves its imposition to the discretion of national
supervisory authorities, but establishes reporting obligations in order to collect
necessary information which will support its future introduction as a binding measure.75
In practice, the leverage ratio is the division of the institution’s capital by its total
70
71
ibid ‘CRR’ Art 406, 408-412
72
Graeme Baber, ‘Basel III implementation and the European Union: the proposed Capital
Requirements Regulation (CRR)’ [2012] Company Lawyer 386 at 396
73
COM(2011) 452 final Art 403
74
75
ibid 14 (Part 1, para 5.6)

34
exposure and the Regulation provides detailed instructions of measuring the capital and
exposure values.76
Before closing with the Capital Requirements Regulation, some remarks have to be
made in regards to the significance of the EU officials’ decision to employ a regulation
as the legislative instrument which will embody such extensive reforms. The
importance lies within the difference between a regulation and a directive. In contrast
with a directive, the fact that a regulation is not subjected to any implementation
procedures means that the new framework will be automatically applicable to 27
different jurisdictions. This creates an integrated regime – a ‘single rulebook’ - which
guarantees regulatory coherence throughout the Union. The efficiency of the regulatory
process allows authorities to respond swifter to market fluctuations and prevent
distortions. Furthermore, by eradicating differences in implementation, the new
regulation signifies important progress towards certainty and transparency within the
banking sector.77
As it was mentioned earlier, the implementation of ‘Basel III’ recommendations is still
in progress. Beyond any doubt, it is by far the most extensive regulatory activity ever
undertaken in relation to the banking sector, commensurate with the severity of the
crisis it is called to resolve. As a natural consequence the recommended reforms have
attracted a lot of attention and triggered endless debates over the possible results they
may bring. The following chapter will compare the expectations of the regulators with
the first reactions of the banking system to the news of reform and close with the
76
77
Joosen (n 52) 47

35
arguments of the dissenting voices which believe that overregulation may lead to
unanticipated results.

36
4. Criticism
4.1 Expectations and Assessment:
The reform is expected to create a safe and transparent financial system, which is able to
meet the needs of economy and society. In a period of recession, regulators expressed
their faith that the new framework will remobilise the economic variables which
promote sustainable growth and enable the financial system to steadily lubricate the
wheels of real economy. The measures adopted by Basel and the EU aspire to increase
not only the resilience of the banking sector, but also the financial system as a whole by
reinforcing the capacity of market infrastructures and non-bank financial institutions to
absorb shocks resulting from a potential bank failure.78
In specific, proposed and agreed reforms are expected to guard the credit and financial
institutions from systemic exposure to risks arising from the uncontrolled trading of
derivatives, the frivolous risk assessment of securities and overreliance to limited
sources of wholesale funding. In addition, the new regime is expected to prevent the
formation of bubbles in the values of capital assets, contain the endless circle of debt
which burdens real economy and abolish any regulatory parameters which encourage
procyclical behaviour within the system. In regards to the shock absorbing capacity of
market infrastructures and other financial institutions, the coherent nature in the
implementation of the new framework is anticipated to significantly reduce contagion
by promoting more responsible internal governance policies and provides to supervisory
78
‘Report of High-level Expert Group on Reforming the Structure of the EU Banking Sector’ (HLEG
October 2012) 67 http://ec.europa.eu/internal_market/bank/docs/high-level_expert_group/liikanen-
report/final_report_en.pdf accessed 15 October 2013 (Liikanen report)

37
authorities the necessary tools for monitoring the systemic risk. Moreover, the adoption
of new capital and liquidity buffers is expected to restore confidence of depositors to the
banking sector and minimize the chances of bank-runs in the event of future failure.
Lastly, the ultimate intention is to reach a degree of stability and transparency where no
institution will be considered ‘too big to fail’ by reducing co-dependency and, therefore,
removing the fear of another bailout scenario.79
In evaluating the new regulatory and supervisory framework it is important to
acknowledge the contribution of the newly introduced shock-absorbent capital
requirements in enhancing the financial sector’s protection against risk exposure and
delimiting the chances of failure. Financial experts have recognised that the ‘Basel III’
initiative is a positive development in the struggle towards effective supervision capital
adequacy and containment of systemic risk and fully support its consistent
implementation.80
However, critics have noticed that some of the proposed reforms may not be enough to
provide with an absolute answer to regulatory weaknesses which failed to contain the
crisis. Although, ‘Basel III’ implements measures which address trading and derivatives
exposures, experts underline that the insistence of regulators to rely on requirements
based mainly on risk-weighted assets indicates that officials have not yet understood the
necessity of additional capital measures which will counterbalance the unforeseeable
risk of certain activities. According to its critics, the new framework does little to
contain systemic exposure to risks arising from complex combinations of innovative
trading transactions and traditional banking activities (swaps, securities etc).
79
ibid 67-68
80
ibid 71

38
Furthermore, it is alleged that the new requirements failed to provide with a
comprehensive response both to the threat limited sources of funding pose to
sustainable liquidity and to the difficulties in assessing counterparty credit risk. Another
point of which attracted criticism is the fact that in a period when centralisation of
supervision and regulatory coherence are regarded as the only viable solution, the new
regime leaves the calculation of risk weights of certain exposures to national authorities.
An example is the discretion of national authorities in the calculation of the
countercyclical buffer against risk from assets like mortgage-backed securities which
played a central role in the evolution of the crisis.81
Ultimately, despite the criticism it is widely accepted that the new regime addressed
most systemic vulnerabilities which allowed contagion to spread and the crisis to
evolve. Thus, it can be argued that the recommended changes are in the right direction.
Reasonably, the fact that ‘Basel III’ is based on the ‘Basel II’ structure, raises concerns
over its potential to achieve its purpose and it is suggested that reform should have been
deeper since the same areas where already regulated. For this reason, there are many
voices which suggest that regulators should consider additional non-risk-based capital
buffers which supplement risk-based requirements and further guarantee systemic
stability.82
4.2 How has the banking system responded to the news of tighter regulation so far?
In addition to the theoretical approaches in evaluating the impact the new regulatory
framework may have, it is equally important to assess how the banking system
responded in practice.
81
ibid 72
82
ibid

39
One of the main observations is the impact additional capital requirements have on the
cost of borrowing. The findings of numerous studies indicate that stricter requirements
on capital conservation will lead to the increase of lending spreads, which depending on
the jurisdiction will vary between 6 and 15 basis points.83
An empirical research which was conducted by the International Monetary Fund
affirmed the above theoretical estimations. A comparison between the interest rates of
the 100 largest banks has shown that a 1% increase in the capital ratios has brought an
average raise of 0.12% to interest rates. Moreover, the gradual introduction of the
further capital buffers when normal credit conditions are restored is expected to bring
and approximate rise of loan spreads within the range of 16 to 31 basis points which is
translated to an additional rise of loan rates within the same specimen. Those increases
in the cost of borrowing are expected to reduce loans by 2.5%. Even more disturbing is
the fact that this number increases significantly when the estimation is not confined to
the 100 largest institutions. Furthermore, country-by-country estimations present
significant differences in loan reduction depending on the strictness of the capital
conservation policies. A straight forward example is the variation between Canada and
Japan where the same capital requirements were imposed. In Canada loan spreads
remained the same but in Japan they increased by 26 basis points.84
4.3 Can regulation backfire?
The main argument supporting financial regulation is that it safeguards financial
stability. The consequences of deregulation are quite severe and became quite evident
83
Thomas F. Cosimano and Dalia S. Hakura, ‘Bank Behavior in Response to Basel III: A Cross-Country
Analysis’ (May 2011) IMF Working Paper 11/119, 3-4
http://www.imf.org/external/pubs/ft/wp/2011/wp11119.pdf accessed on 22 February 2013
84
ibid 5-6

40
by the financial crisis; therefore one might find it relatively easy to argue against it. As
described throughout this research, this reality has triggered during the past couple of
decades a global initiative to over-regulate the financial sector. However, it has to be
underlined overregulation quite often may bring the opposite results.
A hidden consequence of regulation is the cost of implementation and the additional
work it imposes to financial and credit institutions. For example, the Basel
recommendations require the adoption of complex internal risk assessment mechanisms
and specially designated committees. Furthermore, it has been argued that those
requirements have a negative impact on competition, either because their application
varies between jurisdictions or it is easier for larger institutions to implement them.85
Another consequence of overregulation can be drawn from the conclusions of the
aforementioned data regarding the practical impact of ‘Basel III’, especially in the cost
of borrowing. It can be suggested that the imposition of higher capital requirements is
lacking macroprudential perspective since it focuses on securing adequate capitalisation
and liquidity within the financial system, when at the same time it increases lending
rates and transfers shortage of liquidity to real economy.86
Lastly, excessive regulation has proven to create significant incentives for regulatory
arbitrage. It has been observed that the high costs of implementation paralleled with the
profit-seeking appetite of the sector has driven institutions to withdraw from traditional
banking and engage into to new activities, termed as ‘shadow banking’. In measuring
the gravity of the incentive, it has been estimated that a corporation could save $1.6
million when borrowing $1 billion from an institution which evaded the adoption of the
new capital charge. It was the same reasons which caused financial institutions to
85
Charles Goodhart, Philipp Hartmann, David Llewellyn, Liliana Rojas-Suarez and Steven Weisbrod,
Financial Regulation: Why, how, where and now? (Routledge 1998) 64-65
86
Cosimano and Hakura (n 6) 6

41
engage into activities involving innovative financial instruments with unforeseen risk
exposure and resulted to catastrophe.87
87
ibid 6; Goodhart (n 85) 63-64

42
5. Conclusive Comments
Since the first Concordat on banking supervision in 1975 the international position
towards banking regulation has changed numerous times and evolved from generalised
directions to a comprehensive framework which includes detailed descriptions of ratios,
models of internal risk assessment and complex mathematical formulas. The vast
difference in depth between the subsequent regimes came as a response to the rapid and
substantial changes the financial system underwent since the Committee’s
establishment. The main idea, however, in all of them was that in a globalised financial
system the answer to instability is regulatory coherence.
The truth is, however, that despite the incremental approach adopted in its
recommendations the Committee failed to prevent the catastrophic consequences of the
financial crisis. Moreover, every regulatory initiative was triggered by a failure of an
institution but all of them were proven insufficient.
With the ‘Basel III’ package, the Committee expects to end this negative tradition. The
new framework promises to implement new policies which will address excessive
leverage, guarantee liquidity and capture risk exposures arising from shadow banking.
Furthermore, the Committee claims the new rules remove the procyclical element of the
previous framework and address systemic interconnectedness in regards to contagion.
The parallel process which was followed within the EU indicates the Union’s
commitment to take all necessary measures which will prevent such crisis from
reoccurring and nullify the chances of further bailouts. Moreover, the new Capital

43
Requirements Regulation represents the Union’s commitment to the idea of banking
integration and promotes regulatory coherence.
Nevertheless, it is necessary to acknowledge that this time the work of regulators faced
much bigger challenges. The consequences of the crisis were severe and the new
framework had to strike a balance between the imposition of stricter requirements which
would guarantee systemic stability and the taking up of policies which would promote
growth and lead the world out of recession.
There have been voices of scrutiny which accuse the new regime on both sides. One
side suggests that requirements had to be stricter and the calculation of capital buffers
independent from the sector’s exposure to risk. In general, the supporters of this view
believe that the reform should abolish the failed concept of measuring capital adequacy
in relation with risk-weighted assets. The other side of criticism proclaims the negative
impact of overregulation by arguing that stricter requirements will increase the cost of
lending and choke real economy.
Under the present financial circumstances and the temporal proximity of the crisis, the
truth is that both arguments sound equally convincing. It is, however, in the present
author’s view that it is very early to extract safe conclusions on the impact of the new
regime. It seems more prudent to allow the new framework to complete its circle of
implementation before deciding over the effectiveness of its capital buffers or its long-
term implications on lending rates. Especially when the three institutions participating
in the EU’s legislative procedure have not reached an agreement over the final texts
which will implement the new regime.

44
All in all, the ‘Basel III’ package can be characterised as a positive step towards
financial stability. However, the ever-evolving nature of banking business requires
regulators to be alert and ready to face new challenges.

1
Table of Statutes
Directives
1. Directive 2009/111
2. Commission Directive 2009/27
3. Commission Directive 2009/83
4. Directive 2010/76
Proposals
1. Commission, ‘Proposal for a Directive of the European Parliament and of the
Council on the Access to the Activity of Credit Institutions and the Prudential
Supervision of Credit Institutions and Investment Firms and Amending
Directive 2002/87 of the European Parliament and of the Council on the
Supplementary Supervision of Credit Institutions, Insurance Undertakings and
Investment Firms in a Financial Conglomerate (Capital Requirements Directive
IV)’ COM(2011) 453 final
2. —— ‘Proposal for a Regulation of the European Parliament and of the Council
on Prudential Requirements for Credit Institutions and Investment Firms
(Capital Requirements Regulation)’ COM(2011) 452 final

2
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6
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