EBA leans against Basel III in excluding unrealized gains from Regulatory Capital

EBA yesterday published a Discussion Paper (DP) on the exclusion of unrealized gains from regulatory capital. As an advice to the European Commission it basically supports  the current European system of prudential filters – that is, only the unrealized gains part (banks will have to include unrealized losses into capital).

EBA’s departure from Basel III is limited, and if you read the DP, actually quite sensible. Where Basel III requires the inclusion of both unrealized gains and losses into capital, EBA’s  discussion paper addresses only the unrealized gains, and not even all of them.

Interestingly, the DP mentions the level playing field, but it does not mention the recent US move to require only banks with $250bn of total assets to apply Basel III — and have only the big banks include unrealized gains and losses into regulatory capital, see my earlier post on this departure from Basel III.

Here’s my summary of the DP, with references to the text of the DP in brackets:

The Discussion Paper justifies a departure from Basel III on unrealized gains (para 19). But the departure, the exclusion of unrealized gains from capital, affects mainly the unrealized gains on debt instruments valued at Fair Value (para 34, 41, 65). This is about the available-for-sale (AFS) category for debt instruments. Then again, the deductions will likely only affect the net unrealized gains on these instruments (para 70). This is the tip of the iceberg of AFS debt instruments, as within the pool of AFS debt instruments there may be many unrealized gains that are offset by unrealized losses.

EBA appears not too worried about the deduction of unrealized gains on liquid assets (equity instruments, shares). This deduction shall not be a real problem for banks. In good times, they can circumvent the deduction by crystallizing unrealized gains. This is accepted practice, folklore,  fine. In bad times, the banks my not be able to crystallize – the deduction then does its prudential work (Section 5.3).

The DP  outscopes Fair Value Option (in section 5.3.2) and Trading Book assets (para 100), right.

The DP extends the  deduction of unrealized gains on debt instruments to other illiquid assets, such as property (para 119).