The fine line between competitiveness and financial stability

Let’s be honest: European banks are currently doing quite well, mostly due to high interest margins. But unfortunately, that does nothing to counteract long term trends. Ever since the financial crisis in 2008, US institutions have been structurally more profitable and have continued to expand their global market shares. JPMorgan Chase’s market capitalisation is 13.7 times larger than that of Deutsche Bank! Only one European institution is included in the list of the 20 largest banks in the world: Santander, squeaking in at number 20.

Why is that? Well, to begin, US banks are operating from a stronger economic position. The GDP in the USA is now approximately 87 percent higher than the GDP before the 2008 crisis. Meanwhile, EU member-state economies have grown by just 13 percent over the same time period. But it’s important to note that Indian, Australian and Canadian banks are also pulling ahead of their European competitors.

There can really only be one explanation: regulation is a decisive competitive factor that has a real impact on earnings power – even more than in other sectors. Capital requirements and the work of supervisory authorities play a major role and must be fine-tuned in order to ensure that European banks are both stable and competitive. Unfortunately, the European implementation of the international banking package concluded after 2008 has increasingly become a competitive disadvantage for European banks, particularly smaller institutions.

When examined more closely, the results are even more concerning: in the name of “harmonisation”, branch supervisory bodies have developed their own rule-making dynamic that is particularly questionable in terms of proportionality and legal accountability. The result is an excessively complex, increasingly rigid and formalised system.

Basel and own funds

What, then, do we need to fine tune in order to ensure that the regulations in question no longer have a negative effect on European competitiveness? To start, we need to take a closer look at what exactly capital requirements mean for the financial sector. As with many other businesses, banks finance their operations using both equity and debenture capital. The latter is made up, among other things, of their clients’ demand deposits. These deposits are transformed by the bank into productive applications, which necessarily involves risk. In order to protect depositors and foster financial stability, regulations therefore dictate that banks must keep own funds available. The amount of own funds they must retain is risk-weighted based on their assets. As such, own funds are at the top of the hierarchy of liability.

That means that if a bank wants to increase its loan portfolio or risk, it needs to increase the amount of own funds it retains, for example by reinvesting profits or increasing capital. To begin, then, capital requirements have a direct effect on banks’ business models and conditions. And of course, excessively high requirements could stunt lending. The result is that banking supervisory law requires that regulations balance the benefits to financial stability against the consequences for overall economic efficiency.

In order to prevent a race to the bottom, central banks and supervisory authorities have, since the 1980s, worked together in the Basel Committee on Banking Supervision (BCBS) to develop international standards for capitalisation. Basel III, from 2010, incorporated lessons from the crisis and included both a quantitative and qualitative increase in capital requirements. Within just five years, banks had increased their Tier 1 capital by over 60 percent – despite poor earnings and a complicated market environment. The fact that banks were able to improve their resilience so quickly and so substantially was remarkable, and a clear sign that they knew this development was both appropriate and necessary. Unfortunately, this significant achievement was largely ignored by both the public and the media.

The level playing field is at risk

The current banking package (Basel IV) set the goal, under pressure from the United States, of increasing the comparability of risk-weighted assets (RWAs). Basel IV therefore forces banks to use standard models instead of internal ratings-based (IRB) approaches. The latter provide for more risk-sensitive management and can therefore reduce regulatory capital requirements accordingly. The output floor requires that RWAs from internal ratings-based approaches must equal at least 72.5 percent of the amounts arrived at using standard approaches. 

In the EU, Basel IV came into force at the beginning of 2025 via amendments to the CRR. The output floor is now coming into effect step-by-step as part of a phase-in period. Model calculations show that European banks will be disproportionately burdened by these amendments. Unlike US-institutions, European universal banks largely use their own models, as approved by supervisory authorities. This difference arose from the political decision to apply Basel II broadly to all institutions within Europe. In the USA, on the other hand, Basel is graduated, applied based on the total assets (known as tailoring): only banks with over 750 billion US dollars in total assets are subject to the full regime. 

At present, there is still no concrete proposal for implementing Basel IV in the USA. Quite the opposite: the current US government has indicated that they plan to apply Basel IV only selectively. That is, they will increase tailoring and have said they intend to make significant changes to the market risk calculations for capital requirements (FRTB) for US investment banks in particular. Statements by the US Secretary of the Treasury indicate not just a critical attitude towards Basel IV, but indeed a certain scepticism regarding the regulations that have already been implemented. 

In the current political climate, therefore, we can’t rule out the possibility that the USA will switch tracks and move towards deregulation. Of course, differences in implementation between the USA and Europe would seriously endanger competitive conditions. In other words, the level playing field is at risk. While the European Commission has reacted by delaying the introduction of FRTB, this simply will not be enough to fix the issue. 

European rules are too complex

One unique problem for the European banking sector arises from the multi-step legislative process that is preferred for the financial services sector, known as the Lamfalussy process. In this process, political frameworks are set via basic legislation from both the European Council and European Parliament (level 1). The European Commission can then – provided the basic legislation allows it – create delegated regulations or implementing regulations to specify technical details (level 2). Frequently, European supervisory authorities then prepare for implementation, creating joint standards that allow for harmonised supervisory praxis by national authorities (level 3). The Lamfalussy process is supposed to simplify and speed-up implementation of EU laws within the financial services sector. But unfortunately, what it does instead is increase complexity. And that’s without even mentioning the fact that it raises questions as to its constitutionality.

Delegated and implementing regulations can be applied excessively, as clearly demonstrated in the case of the current banking package. The European Banking Authority (EBA) is charged with preparing 140 ‘legal products’, with a particular focus on regulatory technical standards and implementing regulations. In practice, this means that the EBA presents the European Commission with their prepared drafts. There is then a three-month review period, after which the draft is accepted or rejected in full. Amendments are only allowed in extremely rare cases and in close cooperation with the EBA. This regularly and effectively reduces the European Commission’s supervisory function to one of simple formal approval.

This is even more problematic than it seems at first glance, because the drafts often contain strategic or politically significant decisions: decisions that are supposedly and explicitly reserved for level 1 legislators. However, the European Council and Parliament seldom intervene, so rarely in fact, that one might as well say “never intervene”. In the case of ITS, they don’t even have the right to object, even though these drafts, usually highly detailed, have proved again and again to be cases of gold-plating. The existing process for creating standards simply does not do justice to the political significance of many of these regulations.

On level 3, the EBA can publish guidelines and recommendations in order to create effective supervisory practices and ensure joint, coherent application of Union law. In order to ensure supervisory convergence, they can even develop entirely new regulatory instruments. This includes, for example, the EBA Q&As, which allow every natural or legal person to request an interpretation for specific, practical questions. The ECB has been granted similar competencies within the framework of the SSM.

Obviously, this does not grant them general rule-making powers, but it does allow them significant freedom to shape and interpret existing rules. The ECB and EBA are allowed to act provided that they believe that doing so is necessary and in the interest of harmonised supervisory practices. The principle of proportionality, which in Germany is understood as a means to effectively limit administrative action, appears to be entirely absent.

In fact, what happens instead is that we see significant increases in both the number of soft-law instruments and regulatory density. In this environment, several dozen pages of text can be created for what seems like practically no reason at all. For example, the EBA used the general goal of creating “robust governance arrangements” as listed in Article 74(1) CRD – a paragraph that does not even contain the word “outsourcing” – as their justification for the creation of 125 pages of outsourcing guidelines.

EBA guidelines are not, strictly speaking, legally binding. However, supervisory authorities are charged with following guidelines or justifying any noncompliance to the EBA within two months (comply or explain) – which almost never happens in practice.

The very real control mechanism that is soft law clearly contradicts the European legal principle of institutional balance, as established by the ECJ in the Meroni ruling (ECJ C- 9/56, EU:C:1958:133). This ruling states that the delegation of politically normative discretionary decisions to agencies not foreseen by the treaty – such as ESAs – is prohibited.

In addition, the unclear regulatory status of soft law means that there is no clear path to appropriate and effective judicial control. As soft law is not legally binding, a direct nullity suit is not admissible before the ECJ. Legal protection is only available indirectly, for example via preliminary rulings in accordance with Article 267 TFEU within the framework of national court proceedings, or via application of unlawfulness in accordance with Article 277 TFEU in the event that binding legislation is propped up by soft law. However, these methods are very burdensome.

In the end, we have an unstable legal framework that cannot be arbitrated in court. For institutions, this means intransparency, legal confusion and high costs for compliance.     

Rethinking regulations

In light of the above, there is an obvious need for a variety of amendments. The first and foremost is capital requirements: the banking package means that these will steadily increase in Europe until 2033. However, Europe is not acting in a regulatory vacuum. The level playing field is at risk. Insisting on following an outdated roadmap is, at best, inexpedient. Instead, the EU should follow the example of both the United Kingdom and Canada by considering a regulatory moratorium. The moratorium would freeze capital requirements at the 2025 level and create space for a strategic re-evaluation, for example of the output floor. Quite apart from that, a comprehensive review of the overall regulatory system is long overdue. Thankfully, we are beginning to see positive trends in the debate on regulations – but it is essential that we quickly identify and implement practical measures.

In addition, the regulatory process in Europe must be put under the microscope and amended. Technical specifications on level 2 remain necessary, but the number of level 2 mandates must remain limited, and the European Commission’s material right to supervise must be strengthened – with a particular focus on correcting bodies that overstep their mandate. As the Lamfalussy process has, in some cases, shifted responsibility for rulemaking onto specialised authorities, it is more important than ever that we ensure these authorities are legally required to consider competitiveness as a secondary objective of any rules they create. 

In addition, there is an urgent need to clearly limit, on level 3, the inflation of de facto binding soft law that cannot be arbitrated in court. This soft law has a destabilising effect on the legal framework and could be managed by amending the SSM and EBA regulations, for example by adding the principle of proportionality as a strong corrective for harmonisation. In light of all that, we must ask whether a principles-based supervisory approach, allowing (national) authorities more room for interpretation, might not be a better means of achieving the balance between financial stability and competitiveness that is so desperately needed. After all, that’s what really counts – finding the right balance. The results are in, and it’s clear that, so far, competitiveness has not rated nearly high enough in these calculations.

This guest article appeared in the Journal of Banking and Capital Market Law on September 1, 2025.