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Session 2003 - 04
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Standing Committee Debates
Credit Institutions and Investment Firms

Credit Institutions and Investment Firms

European Standing Committee B

Monday 8 November 2004

[Miss Anne Begg in the Chair]

Credit Institutions and Investment Firms

[Relevant Documents: European Union Document No. 11545/04 and Addendums 1-3, draft Directive recasting Directive 2000/12/EC, and Council Directive 93/6/EEC.]

4.1 pm

The Financial Secretary to the Treasury (Mr. Stephen Timms): May I say, Miss Begg, how much I welcome your chairing the Committee? I hope that you and all members of the Committee will find the subject interesting.

Achieving a single market in financial services is a key step towards the ambition among European Union member states of achieving economic reform in Europe and the Lisbon goal of becoming the most competitive and dynamic knowledge-based economy in the world by 2010. An effectively integrated financial services market can, on the right basis, bring about a more competitive marketplace, greater innovation and less costly products. That would benefit customers and competitive providers.

For the past four years, since its endorsement by the European Council in Lisbon, the EU financial services action plan has been the legislative framework for developing a single market in financial services. By March 2000, 39 of the 42 FSAP measures had been adopted in the EU.

One of the central elements in the Commission's plans for a single market is, quite rightly, modern risk-based prudential capital rules. The directives that we are discussing today represent the Commission's proposals for those rules as they apply to credit institutions—banks, building societies and investment firms. The Commission's proposals are designed to be Europe's implementation of the new Basel capital accord. I shall say a few words about the new accord and its approach and then turn to its implementation in the EU.

The original Basel capital accord, agreed in 1988 by the central banks of the G10, set minimum levels of capital for large internationally active banks and has been adopted in more than 100 countries. It has made a valuable contribution to the creation of a single market in the EU and to the creation of high standards of prudential supervision, and it enhances stability in the international banking system. One purpose of regulatory capital requirements is to protect depositors or clients against risks taken by the firm which could result in financial loss.

One of the shortcomings of the original accord is that regulatory capital requirements do not accurately reflect underlying risks as well as they might. The Basel

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committee has, over the past six years, developed a new framework, which was published in June 2004. The new accord updates and modernises the existing rules, taking account of new developments in risk management. It improves the incentives for better risk management, it increases risk sensitivity and it reduces the opportunity for regulatory arbitrage.

The framework is built on three interconnected pillars. Pillar 1 is designed to provide financial institutions with a framework for calculating their minimum regulatory capital requirements. Pillar 2 provides firms and supervisors with the opportunity to review the risk management process and to ensure that appropriate action is taken into account for any shortcomings. Pillar 3 allows for comparisons to be made by other participants in the market and encourages market discipline.

Pillar 1, the minimum capital requirement, consists of elements to cover credit and market risks outlined in the original Basel accord, and includes a new specific capital requirement for operational risk, which is the risk associated with the internal failure of systems or people or with external risks such as terrorism. It offers a menu of approaches for calculating capital requirements, ranging from very straightforward approaches to more sophisticated ones. Pillar 2 introduces a process of supervisory review, a concept already familiar in the United Kingdom, which is intended to ensure that banks have not only adequate capital but adequate systems to ensure good monitoring and management for all their risks. Pillar 3 complements the first two pillars. Its aim is to encourage market discipline by developing a set of disclosure requirements, allowing risk exposures and risk assessment processes, and therefore capital adequacy, to be better compared across different institutions.

The Commission produced a formal proposal for a new capital framework this July, which will revise the existing banking consolidation directive and capital adequacy directive, and implement the new three-pillar framework. As with the implementation of the original Basel accord, the new requirements will apply not only to internationally active banks but to all credit institutions and investment firms in the EU.

We support the Commission's proposals. Improving on the prudential rules in the original accord will bring substantial benefits to the UK and to UK industry. It will help to improve financial stability, encourage firms to improve risk management, and deepen the single market, thereby creating a more level playing field for firms throughout the EU, which will be beneficial. Better prudential capital rules should also reduce the likelihood and the impact of a major banking collapse. The proposals will lead to a more efficient allocation of regulatory capital in the EU, with capital requirements becoming more proportionate to the underlying risks associated with each borrower. The way in which the new directives have been drafted will also increase flexibility in the legal framework, which will allow future market

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developments and improvements in risk management techniques to be more quickly reflected in European law.

The new proposals have been subject to extensive quantitative assessment in Basel and the EU. The UK authorities have worked with the EU and the Basel committee to produce several impact assessments of the framework, the most recent of which was produced last May. A total of 188 banks from the G10 countries participated in the study, along with 177 banks from 30 other countries, all 15 original EU member states and five new EU member states. This country and several others are planning a fourth quantitative impact study to take account of recent developments in the proposals.

The Commission published an extended impact assessment alongside the draft directive that includes summary information from the latest quantitative impact study. At the request of the European Council, the Commission asked PricewaterhouseCoopers to produce a report on the consequences of the new accord for all sectors of the European economy, with particular reference to small and medium-sized firms. That study concluded that the proposals would have a neutral or slightly positive impact on the European economy.

The proposals are complex and lengthy, but they have been developed with great care in close consultation with worldwide and European industry and on the basis of extensive quantitative study. This country's regulatory impact assessment shows that the proposals provide a net benefit for the UK. As well as strengthening the soundness of the international system, which should benefit London as a major international banking centre, the proposals are likely to lead to a fall in regulatory capital requirements for most UK credit institutions, because of the good quality of UK bank lending and the high proportion of retail lending.

The way in which the changes produce an impact on prices and the availability of credit will depend on whether credit institutions adjust the actual level of capital that they hold, as opposed to the level that they must hold for regulatory purposes. In the UK actual capital is significantly above the regulatory requirements. Whether actual capital is adjusted will depend on several factors, including how ratings agencies react, institutions' future business plans and the specific competitive conditions in different markets. I plan to publish the RIA once the Committee has scrutinised the proposal.

There has been wide consultation, and that is continuing; for example, the Treasury undertook a major exercise earlier in the year, before the Commission adopted its proposal, consulting more than 100 firms and organisations. It received a number of written responses. Treasury round tables have been held for industry; we held those jointly with the Financial Services Authority and the Bank of England. We have held some bilateral discussions about the proposals, and the Treasury, the FSA and

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the Bank of England are in frequent contact with the industry about them. Those discussions will carry on throughout the process of negotiation.

The discussions have been very helpful to us in assessing the detailed impact of the proposals, in informing the regulatory impact assessment and in identifying areas of concern and those where change is needed, both at the pre-proposal stage and now, in the Council negotiations. It is widely agreed, including by the Government, that the directive will bring benefits to the UK and UK industry, by improving risk management, bringing about a more prudentially sound financial system and making capital allocation across the EU more efficient. However, because the Basel accord was originally designed for international banks, we need to pay particular attention to the impact of applying the approach more widely to other kinds of credit institution and investment firm.

The UK is working hard with other member states to ensure that the accord is appropriately tailored for all sectors in the EU. Several key UK concerns have been dealt with to the satisfaction of market participants, including, in particular, investment firms, venture capital providers, small and medium-sized companies, commodity firms and retail banking organisations. The Commission has said that the smallest investment firms can keep their current approach to operational risk. It proposes an intermediate treatment for medium-sized firms. The Basel committee is also reviewing the capital charges for trading book activities. That has been a major concern of the largest investment banks.

A more appropriate treatment in relation to venture capital, with lower capital requirements for venture capital exposures, has been introduced in the EU directive, and that better reflects the risk involved for capital provided by banks. The new proposals are likely to reduce the capital requirements for SMEs by up to 25 per cent. Commodity firms will receive improved recognition of commodity collateral arrangements, which will be helpful. The proposal is also good for retail banking and consumers. Retail lending activities will be given lower capital requirements, leading to savings that could be passed on to consumers.

The directive is an ambitious one and presents both challenges and opportunities. It achieves the right balance between competition and effective risk management. It is good for the single market and therefore also for the UK. We have consulted widely among industry and elicited a lot of support for the UK's approach to the accord. Our impact assessments show a broadly positive impact in the UK. Detailed negotiations continue. We have come a long way towards achieving a new Basel accord tailored for EU members and implemented across all 25 EU member states, but we need to continue to address the outstanding points of concern. We are determined to do that.

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Prepared 8 November 2004