European Union banks may get an unfair advantage over global rivals because of the bloc's failure to apply international capital rules properly, a global regulatory body said on Monday.
The Basel Committee on Banking Supervision said in an unusually blunt report that EU rules for implementing the committee's Basel III bank capital accord being phased in from January are "materially non-compliant" in two crucial respects.
Banks could end up holding too little capital against exposures to risky assets like low-rated government debt, or their buffers may not be of high enough quality to absorb losses in a crisis, the committee said.
In a sign of how the Basel report touched a raw nerve, the bloc's financial services chief Michel Barnier immediately issued a statement questioning its findings, saying they were not "supported by rigorous evidence".
The global accord forces lenders across the world to triple to 7 percent their minimum capital buffer to help avoid more taxpayer bailouts like those of the 2007-09 financial crisis.
The committee's inspection team said it was concerned that the two differences in Europe would allow big banks there to hold less capital than they should.
"This potentially has material impact both in terms of financial stability and an international playing field," the Basel report said.
The first key discrepancy covers which instruments can be included in a bank's core buffer. Basel III says it must be common shares while Germany has pushed hard to include what some regulators see as less proven financial instruments.
Core buffers are seen by markets as a key indicator of a bank's strength that underpin investor confidence and many banks already report their ratio ratios under Basel III even though it does not take full effect until 2019.
Ten out of 13 cross-border banks reported overstatements in their core buffers by up to 50 basis points, while three reported overstatements of 100 basis points, the report said.
U.S. banks have long accused their European rivals of "optimizing" risk weights to push down how much capital they need and thereby have an unfair advantage.
The Basel Committee will be hoping that its findings will act as a warning shot to the EU to bring its rules, which are still being finalized, in line with the global accord.
The findings are likely to fuel market concern about the true state of banks in the EU after several "stress tests" forcing lenders to beef up their capital buffers failed to coax investors back into the battered sector.
GOVERNMENT DEBT EXPOSURE
The second area of non-compliance is in how banks use internal models to tot up risks on their books, such as exposures to government debt, thereby determining the size of core buffers.
Basel said there were too many "permanent partial exemptions", meaning that banks could attach too low a risk weighting to sovereign ratings linked to exposures and therefore avoid setting aside more capital.
"The provision was meant to apply only in exceptional circumstances, not broadly," the Basel report said. Some euro zone sovereign debt has been slashed to junk credit rating.
The Basel team found that some EU states allowed only narrow exemptions so that the notional amount of exempted exposure to sovereign debt averaged 5.49 percent of a bank's total exposure.
The most affected bank, however, had a fifth of its exposure to sovereigns treated too leniently.
The Basel Committee published similar, but far less critical, reports on the United States and Japan.
The United States was not compliant in one aspect - how it treats securitization - because it proposed an alternative approach whose impact was hard to quantify at present. Japan's Basel framework was compliant.
(Reporting by Huw Jones; Editing by Helen Massy-Beresford)