DIRECTIVE 2006/48/EC OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions (recast)

DIRECTIVE 2006/49/EC OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 14 June 2006 on the capital adequacy of investment firms and credit institutions (recast)

In order to comply with Basel ii in the European Union (EU), it is important to understand the unusual way in which the European Union works.

Basel II is a best practice. It is an Accord, not an Act. A general framework that gives many levels of freedom to national supervisors. The Basel Committee does not possess any formal supranational supervisory authority, and its conclusions do not have legal force.

Basel ii will be implemented in the European Union via the Capital Requirements Directive (CRD), which is legally binding for every member state of the EU.

This directive is making significant changes to two existing directives that were implementing Basel I in EU: The Banking Consolidation Directive and the Capital Adequacy Directive. Financial institutions have to persuade their regulators that not only they have allocated capital for their risks, but also they have implemented best risk management and governance practices.

Managers and professional having to implement Basel ii in the European Union have to read and understand:

1. The Basel ii papers from the Bank of International Settlements. It is impossible to avoid these papers, because it will be impossible to understand the requirements that follow.

2. The Capital Requirements Directive (in fact there are two directives: 2006/48/EC and 2006/49/EC).

Basel ii is an idea, a best practice. These directives describe what exactly we have to do in order to implement Basel ii in the European Union.

3. The guidelines from the Committee of European Banking Supervisors. An official interpretation of Basel ii as seen using the lenses of the Capital Requirements Directive.

4. The choices of the national supervisors. Basel ii gives many levels of freedom to each country, and professionals have to learn the "national discretions" and options.

5. Each bank's approaches, choices and options. We have very different Basel ii implementations even if we compare banks in the same country using the same approach.

6. The Home/Host challenges for capital allocation and supervision on a consolidated basis.

There are also a lot of challenges. In Sarbanes-Oxley, there are only two different implementations: One for US domestic companies and one for foreign (no US) companies. In Basel II, in 100 countries we have 100 different implementations. Fortunately, we will have fewer differences among the EU countries because of the Capital Requirements Directive, this great opportunity for consistency and harmonization.

But what is a European directive?

We will start from what is the European Union.

The countries that make up the EU (the member states) remain independent sovereign nations but they pool their sovereignty in order to gain a strength and world influence none of them could have on their own.

Member states delegate some of their decision-making powers to shared institutions they have created, so that decisions on specific c matters of joint interest can be made at European level.

It is not a federation like the United States, and it is not an organisation for cooperation between governments, like the United Nations. The EU is unique.

The three main decision-making institutions are the:

A. European Parliament (EP), which represents the EU's citizens and is directly elected by them;

The Parliament has three main roles.

1. Passing European laws - jointly with the Council in many policy areas. The fact that the EP is directly elected by the citizens of the EU helps guarantee the democratic legitimacy of European law.

2. Parliament exercises democratic supervision over the other EU institutions, and in particular the Commission. It has the power to approve or reject the nomination of commissioners, and it has the right to require the Commission as a whole to step down.

3. The power of the purse. Parliament shares with the Council authority over the EU budget and can therefore influence EU spending. It adopts or rejects the budget in its entirety.

B. Council of the European Union, which represents the individual member states;

The Council is the EU's main decision-making body. Like the European Parliament, the Council was set up by the founding Treaties in the 1950s. It represents the member states, and its meetings are attended by one minister from each of the EU's national governments.

Which ministers attend which meeting depends on what subjects are on the agenda. If, for example, the Council is to discuss environmental issues, the meeting will be attended by the environment minister from each EU country and it will be known as the 'Environment Council'.

The EU's relations with the rest of the world are dealt with by the 'General Affairs and External Relations Council'. But this Council configuration also has wider responsibility for general policy issues, so its meetings are attended by whichever minister or state secretary each government chooses.

The Council has six key responsibilities:

1. To pass EU laws - jointly with the European Parliament in many policy areas.

2. To coordinate the broad economic and social policies of the member states.

3. To conclude international agreements between the EU and other countries or international organisations.

4. To approve the EU's budget, jointly with the European Parliament.

5. To define and implement the EU's common foreign and security policy (CFSP) based on guidelines set by the European Council.

6. To coordinate cooperation between the national courts and police forces in criminal matters.

Most of these responsibilities relate to the Community domain - i.e. areas of action where the member states have decided to pool their sovereignty and delegate decision-making powers to the EU institutions. This domain is the 'first pillar' of the European Union.

C. European Commission, which represents the interests of the Union as a whole.

The Commission is independent of national governments. Its job is to represent and uphold the interests of the EU as a whole.

It drafts proposals for new European laws, which it presents to the European Parliament (EP) and the Council.

It is also the EU's executive arm - in other words, it is responsible for implementing the decisions of Parliament and the Council. That means managing the day-to-day business of the European Union: implementing its policies, running its programmes and spending its funds.

Like the EP and the Council, the European Commission was set up in the 1950s under the EU's founding Treaties.

THE CODECISION PROCEDURE

Having been established by the Maastricht Treaty, and extended and adapted by the Treaty of Amsterdam to make it more effective, the codecision procedure now covers 43 areas under the first pillar (based on the Treaty establishing the European Community) following the entry into force of the Treaty of Nice.

As defined in Article 251 of the EC Treaty, the codecision procedure is the legislative procedure which is central to the Community's decision-making system. It is based on the principle of parity and means that neither institution (European Parliament or Council) may adopt legislation without the other's assent.

The 'institutional triangle' produces the policies and laws that apply throughout the EU. In principle, it is the Commission that proposes new laws, but it is the Parliament and Council that adopts them. The Commission and the member states then implement them, and the Commission enforces them.

If we want to add a fourth body, it should be the Court of Justice of the European Communities (often referred to simply as 'the Court'). It is based in Luxembourg. Its job is to make sure that EU legislation is interpreted and applied in the same way in all EU countries, so that the law is equal for everyone.

It ensures, for example, that national courts do not give different rulings on the same issue. The Court also makes sure that EU member states and institutions do what the law requires. The Court has the power to settle legal disputes between EU member states, EU institutions, businesses and individuals.

1. Scope of application
Only a few financial institutions have to implement Basel II in the Unites States. Only core banks ($250 billion or more consolidated total assets, or $10 billion or more total on-balance sheet foreign exposure) have to implement Basel ii. These banks will implement the advanced approaches only.

All financial institutions have to implement Basel ii in the European Economic Area. These banks do not have to implement the advanced approaches only. They may implement simpler approaches, especially for a part of their portfolio.

2. Pillar 2
Financial institutions in the European Economic Area have to implement the detailed guidelines of the Committee of European Banking Supervisors (CEBS) for the application of the Supervisory Review Process.

The rules in the United States are more general. There are fewer guidelines or details.

3. Definition of Default
In the United States, for wholesale exposures, default is triggered by the non-accrual status, i.e. it includes well-secured past due amounts. For retail exposures, there are two benchmarks at 180 days and 120 days respectively.

In the European Economic Area they follow the general 90 days definition of the Basel ii Accord.

4. The Expected Loss Given Default (ELGD)
In the US, for each wholesale exposure and each segment of retail exposures, banks must directly estimate the parameters for the calculation of the:

A. Loss Given Default (LGD)
B. Expected Loss Given Default (ELGD)

In the Basel papers (and the European implementation) there is nothing about the ELGD.

LGD is defined as our best guess of the economic loss that would be incurred if the exposure were to default within one-year during economic downturn conditions.

ELGD is defined as our best guess of a bank's empirically based best estimate of the default-weighted average economic loss per dollar of EAD, which the bank expects to incur in the event that the obligor of the wholesale exposure defaults; or the loss the bank would expect to incur on a segment of retail exposures that defaults within a one-year horizon. The ELGD estimates must incorporate a mix of economic conditions.