Doubts are hovering over the timely implementation of the Basel II capital adequacy mandate in Europe, as the possibility lingers that the European Parliament will fail to clear the ruling smoothly.

Normally, a modified version of the European Commission's proposed wording of a ruling would clear through the parliament in one hearing.

Under that scenario, Basel II would come into force as planned for all European banks and investment firms in two stages: on Jan. 1, 2006, and one year later.

Optimists are confident that the streamlined "single-reading procedure" will go through - there is a lot at stake, apart from it being an important step on the road to harmonizing European Union banking supervision. The hope is that the Economic and Monetary Affairs Committee would give the ruling the nod in June.

But fears have surfaced that implementation could slip back to September.

The delay centers on several European countries objecting to supervision under Basel II being applied at the group level for international banks.

Some nations, fearful of the risk of their taxpayers having to pick up the tab in the case of a bank crisis, could insist on supervision being applied in the nation of the subsidiaries concerned.

"If our people would have to pay, we should have the right to check things over ourselves," is the attitude of some countries. It is a question of principle. The objecting countries center on the smaller states, such as Latvia, that have recently joined the EU.

Basel II - designed to improve risk management procedures - requires banks to assess capital adequacy and align that with credit, market and operational risk to accurately reflect their capital reserves. It requires banks to hold minimum capital of 8 percent of risk. To ensure solvency through the economic cycle, banks hold capital above the minimum requirements. Traditionally, European banks hold higher capital - 13 percent to 14 percent - than U.S. banks, at 11 percent.

The Basel II proposal is based on a trio of principles to help ensure that banks monitor and implement sufficient risk-management practices:

* Minimum capital requirements stipulate capital charges for banks to improve their risk-management and measurement capabilities.

* Supervision requirements create a framework to encourage best risk practices and to clean up other risks.

* Market discipline requires banks to disclose capital structure, risk exposures and capital adequacy in detail.

Pivotal in solving this problem is MEP Alexander Radwan, a German and the European Parliamentary rapporteur - a member of parliament chosen to lead on a subject. His commentary on the European Commission's Capital Requirements Directive, covering Basel II, which came out in early May, suggested a minimum of modifications.

Support for Basel II is also coming from the Brussels-based European Banking Federation, which represents banks in 26 countries in the EU and the associated European Free Trade Association. The federation sees the move as "a window of opportunity to deliver a more coherent framework for supervision in Europe."

Because of the upgrade, banks should be able to match their capital reserves more closely to the type of business that they actually do. They should be able to improve their risk management through the use of more risk-sensitive mechanisms. It will enable regulators to upgrade their standards of supervision, under Pillar 2 of the Basel framework.

The problem here

In the U.S., the possibility of delayed implementation is quite different. It follows a quantitative impact study, "QIS 4," which discovered that Basel II would result in an unprecedented drop in capital requirements.

At worst, credit rating agencies could be obliged to downgrade some U.S. banks. This could happen as the banks reduced their capital reserves, albeit quite legitimately under the new accord.

There would also be a large disparities between banks that apply the protocol and those that do not in the U.S.

The U.S. implementation deadline is 2008.

Back in Europe, a preface to the European Commission's Capital Reserve Directive emphasizes the general need to move up from Basel I, to overcome present shortcomings, including credit risk estimates described as "crude," resulting in weak measure of risk.

Under a "no policy change" scenario, the commission predicted that capital requirements and risks would continue to be misaligned. This would result in limited effectiveness of the prudential rules and increased risks to consumers and financial stability.

Furthermore, the newest and most effective risk management techniques would not be encouraged. Financial services groups operating in more than one European nation would continue to be subject to disproportionate burdens resulting from multiple layers of regulations and supervision.

As the commission sees it, if other parts of the world adopt the Basel II accord, and the EU does not, the EU financial services sector would suffer.

The commission approach is in line with its generic Financial Services Action Plan, which combats entrenched "fragmentation" of various financial services across EU borders. These include savings plans, mortgages, insurance and pensions.

The FSAP is over 90 percent complete.

On the Basel II sector, Alex Schaub, director general of the Internal Market Service in the European Commission, pointed out that the commission's proposal has already been through exhaustive consultation. All sorts of problems have been resolved. Apart from specifically designed rules on capital requirements for lending to small and midsized enterprises, there were measures to give preferential treatment for certain types of venture capital.

In fact, the process, which got off the ground towards the end of 1999, involved three full consultation papers, backed by meetings and so on. Prior to that, Basel II had been drafted by delegates on the Basel drafting committee from the U.S., Canada, Japan and the EU, as represented by the European Commission in Brussels.

It was in June last year that the central bank governors and the heads of the bank supervising authorities in the Group of Ten countries endorsed Basel II. Now, 100 countries intend to implement the agreement, compared with the relative few that apply the Basel I agreement.

In the U.S., the intention is to have only the advanced version of Basel II applied to 10 banks - all of them international - on a compulsory basis. Another 20 could apply it voluntarily.

Banks in Europe are already introducing computerized systems that give a half-way compliance with Basel II. One typical proprietary system offers a package including capital calculation and reporting, financial consolidation, credit and market risk.

It would be a shame if, during this year, it turns out that the EU was going in one direction and the U.S. in another. "Then," as one bystander said, "we shan't have an international agreement ... nor a level playing field!"

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