By Gavin Stamp
BBC News business reporter
The rules should make European banks' finances more transparent
The Swiss city of Basel is not a place one would naturally associate with controversy or far-reaching change.
Yet, the very mention of its name is a cue for fierce arguments within international financial circles.
Basel is giving its name to a new regulatory framework for the financial sector, a set of proposals occupying the minds of the world's leading bankers.
By the end of 2006, international banks operating in the EU, the United States and Japan will have to meet new standards dictating the minimum capital levels they must hold and what information they should disclose about their financial risks.
The new Basel II rules are designed to improve public supervision of banks, reduce the chances of disastrous failures and strengthen the stability of the overall financial system.
Critics argue that the proposed regulations could make banks more risk-averse, forcing many to cut lending to emerging economies and smaller companies.
Banks, for their part, are concerned that the new rules will not be evenly adopted across the EU, enabling some companies in some countries to gain a competitive advantage.
The Basel II framework is the international financial community's second attempt at devising common capital standards for banks operating in developed countries.
The original accord, developed by countries including the United Kingdom, France, Germany, the United States and Japan, came into effect in 1992.
Although its guidelines have never been legally enforceable, it rapidly became the acknowledged benchmark for a bank's solvency requirements and has been adopted by more than 100 countries.
WHAT IS THE BASEL II FRAMEWORK?
Basel II sets out principles by which banks should assess if they hold enough capital and how regulators have to scrutinise their internal controls
International banks active in Belgium, Canada, France, Germany, Italy, Japan, Luxemburg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and United States must adopt the new framework by the end of 2006
The existing rules are now widely considered out of date, made obsolete by business and technological advances, particularly banks' use of more sophisticated and complicated processes to manage their financial risk.
In light of this, the signatories agreed major changes to the framework last year.
Force of law
As with many a sequel, however, there are those who doubt it will improve on the original. Some fear it will place excessive burdens on business, others that it will be watered down to the point of irrelevance.
Also, the stakes are much higher this time around.
The revised framework will form the core of a draft European Commission directive - the EU's single largest piece of financial legislation - regulating banks and investment firms operating in the Union's 25 member states from 2008.
Europe's largest banks seem to agree that Basel II is an improvement on its predecessor, but many have doubts about how successfully it can be implemented.
"We see both opportunities and threats in Basel II," Tom de Swaan, chief financial officer of ABN Amro, told a recent conference on banking regulation at the London School of Economics.
The new rules will affect 7,500 European banks including ABN Amro
"I think that if we started with a blank sheet of paper today we would come up with something else, but we can't do that because there was an existing accord."
Since 1992, banks have been required to hold a minimum level of capital in reserve to protect themselves against unexpected losses - which most often causes banks to fold - and to aid future growth.
The limit was designed to instil public confidence in the banking system and to ensure that banks continued to lend in a downturn, when credit is most scarcely available.
Types of risk
The weakness of the current system is that it does not discriminate between the creditworthiness of individual borrowers, whether governments, multinational companies or small businesses.
Basel II tries to provide a more accurate picture of a bank's risk profile while giving companies greater incentives to make their business planning more risk-sensitive.
It identifies a cost for potential losses stemming from 'operational risk', such as the failure of internal systems or human errors.
John Mooney, Global Head of Institutional and Corporate Credits at Deutsche Bank, defends this, saying that many operational failures happen "unwittingly".
"Often the decisions which sink a bank are taken some way down an organisation where the objectives of the people making the decisions are not necessarily aligned with the objectives of the bank," he says.
The original Basel agreement sought to strike a balance between safeguarding banks from the threat of sudden collapse and ensuring the most efficient use of funds in the real economy.
Some believe the rules will reduce investment in emerging markets
There have been concerns that Basel II may result in a sharp fall in the amount of capital held by Europe's 7,500 banks, threatening the EU's financial stability.
In a study last year, PricewaterhouseCoopers suggested that capital levels could fall by 5%, but argued that this kind of fall would not pose any significant threat.
In fact, it believes this may have a positive impact if banks pass on potential savings - estimated at up to 100bn euros - onto their customers.
However, it is the enhanced role of regulators and not the potential economic benefits of Basel II which most concern banks.
They fear a battle between regulators in their home country and the multiple countries in which they operate may lead to spiralling compliance costs.
Most global banks manage their financial risk at a group level, usually in their country of origin.
They fear regulators in 'host' countries will be loath to give up their autonomy in supervising local operations, fuelling conflict.
"Basel II is a product of the increased globalization of the financial sector, but in many instances the views of politicians have not kept pace with the reality," Mr de Swaan says.
COMPANIES BOUND BY EU DIRECTIVE IN THE UK
Yes: Banks, building societies, investment firms
No: Credit unions, independent financial advisors, insurance/mortgage brokers
Source: Financial Services Authority
Ingrid Bonde, director general of the Swedish Financial Services Authority, admits that the new framework must be "consistently" implemented if it is to achieve its objectives.
"It is clear to me that the basic EU model (of supervision) is not realistic where the bank is of systemic importance in several countries," she warns.
Basel II will also significantly increase the burden of responsibility on Europe's financial regulators and some observers are worried about how they will cope.
"Supervisors will need to have people who are equally as talented as the people who build the (risk) models and run them," says Professor Richard Herring, from the University of Pennsylvania.
"You cannot staff an operation purely out of patriotism."