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Europe torpedoes Basel IV as it struggles to contain Deutsche fears

As amarket panic threatens to engulf Deutsche Bank and questions hang over Italy's financialsector, signs are emerging of a European strategy to reform its banks and kick-startlending, by diluting post-crisis financial regulation dubbed "" and cleaning upnonperforming loans.

Almosttwo years after the ECB centralized control of the EU's biggest lenders underone supervisor, officials are making it clear that the continent's bankingsystem, already struggling with negative interest rates at a time whenborrowers are overburdened with debt, cannot afford the additional capitalcharges championed by U.S. officials within the world's top banking regulator.

Europeannations, together with Japan, may have sufficient strength on the BaselCommittee for Banking Supervision to block elements of upcoming revisions torules governing how banks measure risk. Even if the Committee were to approvesuch changes, the European Commission would refuse to implement them if theyboosted capital requirements, one of its vice presidents, Valdis Dombrovskis,said Sept. 29, in the most explicit public statement of European resistance tothe proposals so far.

Europeis putting its foot down as it struggles with the challenge of €360 billion inbad loans in Italy alone, and as negative rates squeeze banks' margins acrossthe continent. Fears over Deutsche Bank's capital levels as it faces a possible $14 billion U.S.fine — equivalent to 90% of its current market capitalization — have promptedtalk that the German government might be forced to buy shares.

Widelybut unofficially referred to as "Basel IV," the package of measuresaims to reduce the variability between different lenders' calculations of theriskiness of their loans and other assets, in what would be the final touchesto Basel III reforms that have bolstered banks' capital since the financial crisis.Proposals include changes to rules governing in-house mathematical models usedby bigger banks to calculate risk, and limiting the amount they can vary fromoff-the-shelf standard models, which are also set to be adjusted.

Seniorglobal regulators say the changes would not add "significantly" tocapital charges, although banks whose models vary greatly from average riskcalculations would be hit harder. Bankers, however, are nervous, with KPMGcalculating a €350 billion increase to international banks' capitalrequirements.

"Regulatorsin Europe have been quite clear recently and quite keen to go out and say thatthe expectation is that the risk weights, and the capital amount for thesystem, is not going to significantly increase," said Laurent Frings, ?global head of creditresearch at Aberdeen Asset Management.

"Pushingthe risk weights higher is going to make the problems they're facing with theeconomy and providing credit to the real economy much more difficult, and westill have specific issues in Germany and Italy," he said in an interview,noting that while U.S. officials argue for tougher rules, their banking systemis structurally different to Europe's.

Hardening stance

Europeanbanks' relatively low risk weights reflect their larger share of corporatefinance than that of banks in the U.S., with its bigger bond markets. Europeanlenders also largely retain mortgages on their own books, whereas U.S. bankssell theirs to state-sponsored Fannie Mae and Freddie Mac.

WithEurope massing the ranks against Basel IV, a deal may now be impossible, Fringssaid, and if one were to be reached, any resulting increases in risk-weightedassets would likely be mitigated by measures such as allowing bank-specificPillar 2 capital requirements to be counted toward minimum regulatory ratios.

Althoughsecurities held by banks for trading may see increased risk weights, moves torestrict the use of banks' own proprietary models are set to be watered down,said Patricia Jackson, a senior adviser at EY who previously served on thecommittee and as head of the Bank of England's financial industry andregulation division. Boosting risk weights on corporate loans andrelatively safe mortgage lending would tend to push banks into riskier activityto maximize returns on capital, as happened under the old Basel I regime,helping to cause the financial crisis, Jackson added in an interview.

Attention on NPLs, Deutsche

Justas they head off higher capital demands, European officials are alsoincreasingly aware of the need to clean up banks' balance sheets. Governmentscould consider using public funds to buy NPLs, European Banking AuthorityChairman Andrea Enria said Sept. 28, warning that without swift action, Europerisks a Japan-style, prolonged slump.  

"Politiciansand the commission need to look at what is going to enable Europe to bounceback and grow," said Jackson, adding that this included putting brakes onBasel IV and cleaning up NPLs.

Europe'shardening stance against Basel IV also comes as Deutsche Bank — named theworld's riskiest by the IMF — is under renewed market attack. Its sharestumbled again Sept. 30, before rebounding after an AFP reportthat the bank was near a $5.4 billion settlement with the U.S. Department ofJustice. A fine booked within 2016 would sap Deutsche's CET1 capital ratio,which stood at 10.8% at the end of June, and could endanger interest paymentson Additional Tier 1 "CoCo" bonds.

Litigationcosts may force a rights issue, which some analysts have speculated thegovernment may have to support amid concerns over the bank's ability to makelong-term returns. Weakened by low margins and sluggish investment banking,Deutsche's profits slumped 98% in the second quarter, but its capital ratiosare above regulatory minima and its liquidity ratio of 124% means that it hassufficient funds to cover its needs for some time even if funding dries up.

In amessage to employees Sept. 30, Deutsche CEO John Cryan said "forces in themarket" were trying to undermine trust in the bank.