30 March 2022

Finance Watch Prudential regulation should not be instrumentalised to distort the banking competitive landscape

France’s move to make Basel III transitional arrangements permanent will not defend EU banks against US ones but only protect the vested interests of European megabanks, vis-à-vis their smaller European competitors

Prudential regulation is both about preserving financial stability and creating a fair competitive landscape between banks of different sizes. Weakening the Basel III framework would damage the level playing field in Europe at the expense of smaller banks. Return on equity, Output floor, SME financing: here is a debunk of common fallacies the banking lobby likes to push forward in an attempt to stop the European Union from delivering on its post-crisis international commitments.

1. The higher return on equity of US banks does not result from a lower equity base

The debate over banking prudential regulation is riddled with misconceptions. One of the most often heard arguments centres on the question of the level playing field between European and American banks in a context where American banks derive a significantly higher return on equity than their European counterparts. The underlying narrative behind the argument is that the higher profitability of US banks would be the result of a different application of the Basel III framework on both sides of the Atlantic.

Unfortunately, this narrative does not correspond to reality. The higher return on equity of large US banks (roughly twice the return on equity of European banks) is the consequence of a higher return on assets, not of a supposedly lower equity base they would benefit from. The reasons why American banks derive a higher return on assets range from an overcapacity of banking assets in Europe, to an unfair access – grounded in US regulatory protectionism – to the US market for non-US banks, to the size and oligopoly practices of American capital markets, among others. In any case, the higher return on equity of American banks cannot be attributed to a supposedly more lenient application of the prudential rules derived from Basel III in the USA. As a matter of fact, the opposite stands true. Witness the current situation regarding the output floor.

2. The Basel III output floor level actually plays in favour of EU banks (!)

Basel III offers banks two possible approaches to calculate risk-weighted assets, and therefore capital requirements: a standardised approach and an internal-ratings based approach (IRB).   By definition, the standardised approach is fixed and it is used mainly by small and medium size banks. In contrast, the internal-ratings based approach gives flexibility and it is predominantly a large banks’ approach.

Without surprise, the flexibility given by the IRB approach to calibrate risk weights creates a temptation for large banks to tweak numbers in their favour. Notably, the ECB found in 2016 that “financial institutions have lower capital charges and at the same time experience higher loan losses under IRB »[1].

Contrary to what some would like to make us believe, the output floor does not have the objective of increasing capital requirements but of limiting the divergence between the two approaches.  This limitation is essential to preserve financial stability in a context where the IRB approach is used by too-big-to-fail banks and, as importantly, to preserve the competitive landscape and give small and medium size banks a chance to compete on a fair basis with large banks.

The US has applied an output floor since the adoption of the Collins amendment in 2010, whereas the EU is only coming up now with a regulation to apply a similar mechanism. US banks are subject to an output floor of 100%, but that does not apply to operational risk and credit value adjustment, resulting in an effective floor of around 75% across large US banks[2] once corrected for methodological differences. This is comparable to the 72.5% output floor that was set by the Basel Committee on Banking Supervision (BCBS) after years of negotiation with banking institutions.

The debate about the output floor is fraught with disingenuous arguments. We are often presented as a so-called proof of the unfairness of its implementation the fact that it will impact European banks and not their American competitors. However, this argument is a distortion of reality: given that US banks are already subject to an (equivalent once retreated) output floor of 75%, there is no surprise that a floor set at 72.5% will have a limited impact on them. Moreover, even after the BCBS 72.5% floor is adopted and implemented, European banks will still be favoured with a lower floor applying to them.

3. Exceptions for SME financing will benefit the biggest banks to the detriment of smaller ones

Prudential regulation should have the objective of ensuring financial stability whilst preserving a fair competitive landscape allowing banks to compete with one another for the benefit of the economy and of society. If they agree with this objective, EU policy-makers should strive for prudential regulation to ensure a fair competitive landscape inside the EU for banks of different sizes and different structures. This is essential as too much concentration of banking assets is detrimental both to financial stability and to the ability of the banking system to serve the best interest of European enterprises.

This is where the concessions made to banking lobbies in the EU 2021 Banking Package run against the interest of the EU economy....

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