This week, a new capital standard has come into force in Europe to cover the counterparty risk that banks assume when contracting financial derivatives with their clients, typically companies, to hedge the financial risks of the latter. This new regulation will result in a very significant increase in the cost of these essential hedging products for corporate risk management.
Despite potentially being a sophisticated product, derivatives fulfill an essential function in the real economy. Companies use derivatives to hedge their financial risks, which allows them to be immunized against adverse movements in financial variables (interest rates, exchange rates, commodity prices, etc.), limiting their risks to those related to the mere development of their own businesses (risks with clients, products, suppliers, new competition, etc.). An increase in the cost of these products could discourage companies from hedging these risks, increasing their insolvency risk.
Like the vast majority of capital regulation, the origin of this standard comes from the Basel Committee. This Committee is an international forum of banking supervisors where they agree on risk measurement standards and commit to implementing them in each of their jurisdictions. While it is true that the participation of supervisors from multiple countries enriches the discussions and analyses carried out in the Committee’s various working groups, it is also true that reaching agreements that take into account the specificities of each geography and adapt perfectly to the particularities of each country is very complicated.
This is the conclusion that the American authorities have reached, having decided to deviate from the counterparty risk standard by partially transposing this regulation and largely limiting the increase in the cost of derivatives that their companies will have to face. In contrast, the European Commission has decided to carry out a faithful implementation of the standard. This situation tilts the competitive playing field between European and American banks, which compete in global markets and will not be able to do so on equal terms in this market segment from now on. Furthermore, as a consequence of the above, European companies will have to face higher financial risk hedging costs than American companies, since the capital requirement significantly influences the cost of all financial products.
As an aggravating factor to the above, European capital markets are less developed than those of other jurisdictions such as the United States or the United Kingdom, which means a high dependence of the real economy on the banking sector and, therefore, it will be difficult for other market participants not affected by this regulation to offer this type of product.
Despite various official documents having recommended the review of this standard in Europe in recent months, it does not appear that a satisfactory solution will be forthcoming in the short term. Both the European Parliament and the High-level Forum on Capital Markets (a high-level working group created by the European Commission to analyze the future development of capital markets in the EU) have recommended the review of the standard, which could materialize in the implementation of the agreement known as Basel III and which will take place after the summer. However, it would be advisable that, if so decided, a fast-track review formula be sought to prevent this detriment that European banks and their clients have to face compared to their global competitors from being prolonged over time.
The arguments against this standard are not limited to those merely related to impact, level playing field for competitors, or the efficiency of this market segment in Europe. There are also technical arguments that would justify a delay in its entry into force. In particular, this standard was calibrated very conservatively in 2005, when the market structure was different and there were a series of problems that, incidentally, have already been partly resolved with other regulations.
Despite the importance of implementing Basel capital standards faithfully at a global level to ensure a level playing field, financial stability, and market certainty, it is necessary that, as is done in other jurisdictions, European authorities implement them taking into account European specificities and the potential collateral effects they may have on the productive fabric of the European Union.
Pedro Cadarso Palomeque, Advisor to the Spanish Banking Association (AEB)
