European versus US Banks
In addition to the flexibility in the application of internal risk-weight models, at least three other differences between European and US banks warrant mention for purposes of placing bank capital reform into context.
The first is that banks are considerably more important to finance in Europe, whereas there is a much greater reliance on the corporate bond market and other nonbank sources of finance in the United States. Merler and Veron (2015) estimate that in 2014, in the euro area bank loans accounted for 88 percent of financing to nonfinancial corporations and debt securities only 12 percent, whereas in the United States the share of loans was only 30 percent and that of debt securities 70 percent. By implication, the stakes in ensuring the safety of the banking system are even higher in Europe than in the United States. Moreover, Europe would likely benefit from greater diversification away from banks toward capital markets. For the United States, a corresponding implication is that policymakers must pay special attention to the spillover effects of bank regulatory reform onto the nonbank (or shadow banking) financial sector.A second difference is in the emerging approaches to resolution of large failing banks. Chapter 5 discusses this issue in the US context. In the euro area, resolution is to take place through the Single Resolution Mechanism within the EU Bank Recovery and Resolution Directive.[13] The Single Supervisory Mechanism, comprising the European Central Bank and national supervisory authorities, determines when a failing bank needs to be resolved. The Single Resolution Board (comprising representatives from the national authorities involved, the Single Resolution Mechanism, and the European Commission) decides whether and when to place the bank in resolution. If it determines that resolution is needed, the bank is either sold or divided into a new bridge “good bank” and a “bad bank,” where shareholders and creditors cover losses on bad assets.
Under conditions of systemic stress, the Single Resolution Mechanism can provide state assistance to recapitalize the bank, but only after shareholders and creditors (excluding insured depositors) first take a “bail-in” loss amounting to 8 percent of the bank's liabilities. After that threshold is reached, the system's Single Resolution Fund can contribute up to 5 percent of the bank's liabilities; still larger losses would require an additional round of creditor bail-in losses. Each member state is to set up financing arrangements funded by contributions from banks and investment firms, to reach a cumulative target of at least 1 percent of deposits over 10 years and merged into the Single Resolution Fund.[14] The more rigid bail-in requirements of the Bank Recovery and Resolution Directive may play a role in the lower ratios of share prices to book values observed in Europe than in the United States as of late 2016 (see appendix 5A).In the United States, the FDIC has long experience in implementing resolutions of failing banks. In contrast, the Single Resolution Mechanism remains untested. The potential for friction between national authorities seeking greater flexibility to avoid politically unpopular bail-in of smaller creditors and the Single Supervisory Mechanism became evident in early 2016 in Italy.[15] In part because of such potential tensions, the scope for the mechanism to deliver “immaculate bankruptcy” for large banks seems unlikely to be much greater than that of the US mechanism resulting from Dodd-Frank.
A third notable difference between European and US banks concerns accounting. European banks use International Financial Reporting Standards (IFRS); US banks use Generally Accepted Accounting Principles (GAAP). Primarily because IFRS does not permit the netting out of derivatives, the reported assets of European banks tend to be larger than would be reported under GAAP. Hoenig (2013) estimates that for the eight US G-SIBs, total assets in 2012 stood at $10.2 trillion under GAAP but would have been reported as $15.9 trillion under IFRS.
As it turns out, this divergence is not as problematic for capital requirements as might be feared. For risk-weighted assets, the risk-weighting process (rather than IFRS or GAAP) determines the outcome, so comparison of the risk-weighted assets denominator for European and US banks is not necessarily distorted. Although in principle the potential for distortion could be greater for the leverage ratio of capital to total assets, the Basel III leverage requirement to be introduced by 2017 pays explicit attention to the treatment of derivatives in a fashion that is comparable for European and US banks.[16] [17] The principal caveat regarding accounting is thus that caution should be used when comparing European to US banks using publicly reported assets.