Author: Nafisatu Wiafe Ansah, LLB University of Padova, 2015-2016
Legal Editor: Bader Kabbani, LLM International Commercial and Economic Law, SOAS, University of London, 2020-2021
Due to the particularly delicate and risky nature of banks, and the importance they play in the socio-economic well-being of society, there has always been the need, and increasingly so, to put in place both prudential requirements regulation and also supervision that guide the actions of those who operate within the banking and financial system and to ensure that the financial institutions, and the markets as a whole, are as stable and safe as possible.
What are Prudential Requirements?
Prudential requirements are a set of requirements that financial market operators are mandated to observe (such as the minimum amount of capital, and minimum liquidity requirements) to control and minimize risks of insolvency, confidence loss or other systemic issues of the banking and financial system, thus ensuring sanity in the banking sector and in the financial system. Indeed, the banking/financial crisis of the late 2000s revealed, on one hand, that banks had insufficient short- and long-term liquidity and, on the hand, that the number of their capital reserves was insufficient for banks to pay their debts as they fell due or even meet depositors’ withdrawal request.
Prudential requirement and their punctual observance by banks are of non-irrelevant importance to sanity in the banking system. In the first place, they are instrumental in preventing crises in the banking sector (that often have rippling effects and extend to the financial market as a whole) because they make sure that banks are more resilient and make provisions for situations of distress. Indeed, studies have shown that “banks subject to less stringent national prudential regulation before the crisis were more likely to require public support during the period 2008-10”[1].
A brief synopsis of prudential requirements in the Basel Accords
The Basel Accords are a set of ever-evolving three international agreements issued by the Basel Committee on Banking Supervision (BCBS) intended to regulate to the banking sector by creating a regulatory framework to manage market and credit risk. The positives of these agreements are that they regulate the proper functioning of the bank – consumer relationship by, on one hand, compelling the former to hold enough cash as reserves so that they are able to meet their financial obligations as they fall due and to withstand turmoil regarding the financial system and, on the other hand, by strengthening transparency, corporate governance and risk management.
Basel I
Basel I was formed in 1988 and enforced by the G10 countries (the majority of whom are part of the EU) in 1992 in an environment that saw the continuous emergence of international banks (and their practice of not holding enough cash reserves), their growing importance and influence in financial markets and the increasing level of interdependency between banks. This agreement required banks to classify their assets into four categories (0% for assets without any risk such as cash; 20% for securities with the highest credit rating; 50% for residential mortgages and 100% for corporate debt which carries the highest risk) based on their weighted risks. The agreement also made it compulsory for banks to adhere minimum ratio of capital to risk-weighted assets of 8%.
Basel II
This was formed in 2004 as an improvement on the first one (especially on the market risk front) and it comprised three fundamental pillars: an expansion of the minimum capital requirement provided in the previous accord; a supervisory mechanism that subjects banks to capital adequacy and internal assessment process; and an improved transparency and market discipline (effective implementation of disclosure as a mode of strengthening market discipline, strengthening bank-consumer trust and encourage sound banking practices).
Basel III
This was formed in 2010 in response to the 2007-2008 global financial crisis. Indeed, the crisis exposed inadequacy in risk management, poor liquidity management, and poor governance in the banking sector. And it pursued the enhancement and strengthening of the three pillars established with the second accord. In particular, it increased financial institutions’ minimum capital requirements (it required more and better capital), it also introduced better-defined liquidity requirements (demanding that liquidity and cash flow are managed more), capital buffers and leverage backstop.
EU legislative framework on Prudential Requirement; the CRD IV package
The principles of the Basel Accords (particularly, the third agreement) find expression in the European Union through Directive 2013/36/EU and Regulation 2013/575/EU, also known as the CRD IV package on capital requirement directive (which builds on the previous CRDs: I in the year 2000, II in 2008 and III in 2009). This package in acknowledging the deficiencies in the banking system that exacerbated the 2007/2008 crisis sought to create legislation that set stronger and more stringent prudential requirements for banks (in terms of capital reserves and sufficient liquidity) and better supervisory so that the resilience of the EU the banking sector is strengthened to better absorb shocks in the economic sector, just as provided for in Basel III.
There are, however, important points of departure from the international agreement. In fact, whiles the capital adequacy measures in Basel III are applicable to banks that have international relevance, the EU package is applicable to all banks operating in the Union (especially, considering the transborder nature of their operations). Undeniably, in adopting the package the EU endeavoured to adapt it to the peculiar characteristics of the geo-political setting by enacting “multi-dimensional regulation and supervision, where you have capital, liquidity and the leverage ratio – which is important because this covers the whole balance sheet of the banks”[2].
The package also introduces some very important such as enhanced governance (with new rules regarding corporate governance and oversight responsibility), enhanced transparency (regarding the activities of banks, as a way of building confidence in banks), systemic risk buffers, and remuneration (to limit moral hazard). The CRD IV package is an integral part of the Single Rulebook, thus ensuring that it finds harmonized application throughout the union.
Conclusion
Definitely, the enactment of prudential requirements is imperative to the proper function of the banking system and to safeguarding the stability of the financial system. Undeniably it is important that continuous measures and rules are implemented to respond to the new problems that emerge in the banking systems. However, a big obstacle to having legislation or rules that respond preemptively to shocks in banking is the rapid rate at which changes happen in the market, so rules are formed only after a distress situation has happened.
BIBLIOGRAPHY
- Angela Maddaloni and Alessandro Scopellit, Prudential regulation, national differences and banking stability, 2019.
- Bryan J. Balin, Basel I, Basel II, and Emerging Markets: A Nontechnical Analysis, 2008.
- Jens-Hinrich Binder Prudential requirements framework and sustainability, 2022.
- Pierre-Richard Agénor, Leonardo Gambacorta, Enisse Kharroubi, and Luiz A. Pereira da Silva, The Effects of Prudential Regulation, Financial Development, and Financial Openness on Economic Growth, 2018.
- Nikos Maragopoulos, Minimum Requirement for Own Funds and Eligible Liabilities (MREL): A Comprehensive Analysis of the New Prudential Requirement for Credit Institutions, 2016.
- Sophie Harnay, Laurence Scialom, The influence of the economic approaches to regulation on banking regulations: a short history of banking regulations, 2015.
CITOGRAPHY
[1] A. Maddaloni and A. Scopelliti. Prudential regulation, national differences and banking stability.2019
[2] European Commission. MEMO. Brussels, 16 July 2013
This article is written within the Academic Essay Project (AEP) organised by LAWELS. AEP aims to increase the number of quality academic writings on legal topics, encourage young lawyers to participate in academic writing, and lay the foundation of an online database on legal science. The team of legal editors and legal writers share their knowledge through high-end essays that we are publishing on our website and social media accounts for the world to read and learn from.
The articles on the LAWELS platform are not, nor are they intended to be legal advice. You should consult a lawyer for individual advice or assessment regarding your own situation. The article only reflects the views of the author.