Frits Bolkestein: "Aligning CAD III with Basel II"

Ladies and gentlemen,

Thank you for your invitation. It is a pleasure to join your discussion on how to ensure that the rules on capital adequacy serve the needs of twenty-first century banking effectively.

I'll begin with an overview of the importance of regulatory capital to the stability of the banking systems and that of the economy and how the new rules will reinforce financial stability. Second, I'll discuss the suitability of the rules for our banking system in Europe, and how we intend to translate the Basel Committee's recommendations into European rules. I would like to close by giving you some insight into the process and timeframe that is guiding our work.

Importance of capital requirements

Let's first look back for a moment to understand the path we've taken. We have since long sought ways to ensure that banks hold sufficient capital relative to the risks they face.

Capital, of course, helps individual banks to weather losses. On a macro scale, requiring all banks to maintain adequate levels of capital helps to safeguard the stability of the overall financial system. This in turn enables banks to provide businesses and consumers with funding and credit through good and bad times. Stability thus promotes a more even pace of long-term economic growth.

The risks involved in lending and borrowing have long been recognised. When Shakespeare's Polonius advised his son, "Neither a borrower nor a lender be, for a loan oft loses both itself and a friend," he was voicing the wisdom of his age (Hamlet).

The age of Polonius has passed, and his advice has been drowned out by contrary opinion. Banks continue to court borrowers who have caused them to lose money in the past.

But banks like all companies seek a healthy balance between risk and opportunity. Because banks serve as key intermediaries of credit within the economy, poor credit decisions harm not just banks, but borrowers as well, depleting the future supply of credit. A banking system that encourages lending to companies or individuals in excess of their ability to repay hurts not just borrowers, but society as a whole.

Objective of the new rules

In the new Basel Accord, we are revising the existing international minimum capital requirements, which are outdated. This will promote the efficient use of banks' capital resources. The current rules are relatively unsophisticated even if, back in 1988, they represented an important step in the development of internationally acceptable standards.

They have since been overtaken by advances in the financial sector, risk management policies and in the economy at large. New technology, the globalisation of financial markets, innovative financial products and services. All this has changed the way that banks measure and manage credit, market, and operational risks in a manner that we could not anticipate 15 years ago. The current rules no longer meet the needs of twenty-first century markets. The new Basel Accord rules will do just that.

Our goal is to go beyond a rules-based structure to an incentive-driven, risk-sensitive and evolutionary system. That will encourage banks themselves to identify, measure, and manage their risks appropriately. In particular, banks making use of the more advanced approaches in the new Accord. They will be able to rely on their own internal ratings of credit exposures when determining how much capital to hold.

A key part of this work is thus to provide banks with the appropriate incentives to improve constantly their processes for measuring and managing risk.

We have come a long way in modern risk management since Charles Dow co-founded the Dow Jones & Company in 1882 to promulgate his ideas about how to get rich in the stock market. He saw that the market moves in waves, and believed it was possible to predict when prices were about to begin their long climbs and falls. Using primitive data, Charles Dow invented technical analysis of the stock markets. This was probably the start of modern risk measurement.

Our new rules will motivate banks to enhance their understanding of the risks they face, and seek better ways to manage them. In doing so, I believe that we are able to reinforce the stability of markets.

We have not moved to acceptance of full credit risk modelling yet. While regulators can perfectly understand the motivation behind banks' desires to do this, most do not view them as realistic. Given the current state of technology, there is still more work to be done to increase regulators' confidence in risk modelling. Technicians say they need to know only a few things to predict the outcomes. The problem is they disagree about precisely what those things are.

Our working method

Because the proposed changes are far reaching, we are working closely together with supervisors, banks, and others involved in the financial sector.

We are also fully committed to transparency. We've released proposals and studies for public review and comment. Last month we received thousands of pages of comment to our Third Consultative Paper. It demonstrates how hard we've been working and how complex the challenge has been.

We are meeting with industry participants and others in a variety of formal and informal settings to exchange views on the proposals. We are enormously appreciative of the comments and questions that we've received. We are very impressed with the quality of those views. Our proposals are being strengthened and improved by the public consultation process.

The latest example is the agreement in Basel on the treatment of expected losses. Of course capital requirements should only be based on unexpected losses. However, regulators have had justifiable doubts about the degree of coverage of expected losses in banks' provisioning.

The recent solution to this shows how seriously public comments are taken. My services have also recently put out a short paper seeking comments.

As Francis Bacon said, "If a man will begin with certainties, he shall end in doubts; but if he is content to begin with doubts, he shall end in certainties."

Suitability and implications of the new rules for Europe

Let me now turn to the suitability of the new rules for Europe, and how we intend to translate the Basel Accord into EU rules.

As you know, the new capital framework will apply to all banks and investment firms in the EU. This is both necessary and desirable.

Necessary - because the Single Market can work only if all actors are confident there is a level playing field;

Desirable - in order to ensure that institutions of all shapes and sizes can benefit from the advantages that the new rules will bring.

Based on the comments we've received, I am pleased to note the continued wide support of industry for this approach. I also believe that the industry very much supports our goal to align regulatory capital more closely to risk.

The fact that we have made our approach namely to apply Basel to all banks and investment firms in the EU clear from the outset has had a positive effect on the work of the Basel Committee. The Commission, together with the 9 EU Member States who sit on the Basel Committee, has worked successfully to ensure that the new Accord is suitable for application in the EU context.

We can see the results in the proposed Basel rules. Three examples:

Firstly, the availability of three different approaches. Particularly important here is what might be called the 'middle way' that is the 'Foundation Approach'. This will make increased risk-sensitivity achievable by a large number of less-complex European banks.

Secondly, the results of the impact study carried out earlier this year ('QIS3') are positive for the European context. They show that smaller institutions will do well under the new rules.

Lastly, important changes have been made concerning the treatment of loans to small-and medium-sized enterprises. They include: (a) modifications to the capital requirements so that they better reflect the underlying risk; (b) greater recognition of collateral provided by small and medium-sized enterprises; and (c) an adjustment to the capital charges based on a borrowing firm's size.

Of course the new Basel rules are not a perfect fit for the European context. And, as we have always promised, we will make modifications where these are necessary.

For example, we are proposing to permit institutions to adopt a 'partial use' approach. That is to allow them to move to the more advanced approaches while using the simpler approaches for some of their business.

Also, in our last Consultation Paper we suggest modified rules for investment firms. For the operational risk of low- and medium-risk investment firms, we suggest a quite modified approach to that previously proposed. This has been welcomed by these firms.

For higher-risk investment firms we continue to consider the issues. However, the higher risk to investors and systemic stability together with level playing field issues suggest that the rules should not differ greatly from those for banks.

The United States is now also seriously considering applying the new Basel rules to its biggest investment firms. These firms will be covered by these rules for their European operations in any case under the new Directive.

The U.S. Securities and Exchange Commission has recently released its draft proposals. Partly this was in response to EU requirements to improve the oversight of these firms.

The European financial press has recently characterised the SEC as the "black hole of consolidated supervision". This is both unfair and incorrect. Stephen Hawking, the originator of the black hole theory ("The Brief History of Time", 1989), described them as having gravity that is so strong that nothing, not even light, can escape their grasp.

Well, I have recently returned from the U.S. where I have spoken with the SEC. I can assure you that, as the draft rules SEC rules show, there is light at the end of the tunnel!

My staff is discussing with the SEC how we can align our rules as much as possible to avoid unnecessary costs and burdens for our financial firms.

Implications for financial regulation and supervision in Europe

The nature of the new capital requirements Framework has implications for the way we do financial regulation and supervision in Europe.

Flexibility

Firstly, it is important that the new rules can be updated in a flexible manner to reflect new developments. The EU must not legislate for yesterday's market. This is essential for the competitiveness of our financial services providers.

We therefore intend to design our Directive proposal so that only the key principles and central requirements need to be decided by co-decision. On the other hand, the detailed elaboration of these provisions should be able to be amended by a relatively quick procedure so-called 'comitology'.

This amendment procedure must of course fully respect the democratic competences of the different European institutions. Moreover it should be based on transparent and consultative processes.

With this in mind, the Commission has just recently adopted a legislative package to restructure the banking committees to carry out the necessary advisory and regulatory functions.

Convergence and consistency

Our approach to regulating risk has to involve a trade-off between flexibility and comparability. The new framework marks a significant step forward in that it will use institutions' own risk assessments as inputs to capital requirements. However this implies a significantly enhanced role for supervisory approval and review.

Industry responses to our Consultative Paper confirm that a maximum consistency and convergence in the interpretation and application of the new rules by supervisors is vital.

At the same time, it is necessary to retain an appropriate scope for the role of supervisory judgement while preserving a level playing field.

We are developing proposals designed to enhance supervisory convergence. For example, to have one 'co-ordinating supervisor' for each cross-border banking group in Europe. This would centre and limit responsibility for consolidated supervision and prudential reporting in one authority.

Industry has supported these suggestions as this would reduce regulatory costs and ensure consistent enforcement across the EU.

We have just recently adopted a decision establishing a Committee of European Banking Supervisors, the 'CEBS'. A key task of this Committee will be to enhance consistency in the application of banking directives and convergence of supervisory practices in an enlarged EU.

We are also looking at including requirements on supervisors to disclose key aspects of the way in which they implement the new framework. This would foster transparency and best supervisory practices.

But we could even go one step further. Another idea, already in our Financial Services Action Plan in 1999, is a European 'rulebook' for and by supervisory authorities. It would detail how the Directive will be applied in day-to-day practice across the EU. I would be interested in your views about this.

Process and timeframe

The finishing line is now within sight. We are now gathering and analysing responses to our Consultative Paper. We will of course also respond to those comments.

As urged by industry we are already revising the draft texts to make them clearer and more consistent. As mentioned earlier, we are looking at ways to increase regulatory convergence and how to best apply the rules to investment firms.

We have also received other detailed comments, one of which deserves a few words. It concerns the proposed treatment of banks' equity and venture capital exposures.

Both venture capital and equity investments often are catalysts for innovation and growth in the economy. At the same time, they can represent high-risk activities for banks. Consequently, the challenge is to design new rules that recognise the underlying risk while not penalising banks that wish to remain involved in venture capital and equity investing.

We should also avoid disrupting equity holdings that have developed under existing capital regulations. To this end, only new equity investments would be captured under the internal ratings-based approach for the first ten years after the date that the new rules are implemented.

Regarding the timeframe, I must stress that we are very disappointed that Basel has once again been delayed. Fortunately, the Basel Committee is now committed to reaching agreement "before mid-2004". This is good. Everybody can set their sights and do what they have to do.

But let me be clear. If we were to face even further delays, the EU would not be able to meet the stated target, namely implementation by the end of 2006. We cannot afford any further postponements.

Conclusion

The new Accord offers us the chance to significantly improve the stability and resilience of our financial system.

There is good progress. But we still need to work hard both in Basel and in Brussels to settle all remaining issues. If there are still concerns, we are ready to discuss them to try to find acceptable solutions.

Industry is encouraged to continue preparations. The Commission is engaged to prepare its legislative proposals and present them to Parliament and Council next summer to have them implemented in time.

Next year when I will speak on this subject, I am confident that the benefits of Basel will have become so obvious that remaining doubts about its completion will have been dispersed. By that time, I hope I will be able to end with one of Shakespeare's most satisfying quotes:

"All's well that ends well" (Promus).