UK fights Brussels over bank capital rules Britain is battling Brussels and Paris to protect its near-unfettered powers to raise capital requirements for banks, as diplomatic talks enter a critical phase over the EU's most politically charged piece of financial legislation. London will on Monday claim an important victory when the European Systemic Risk Board, chaired by Mario Draghi, publishes a letter arguing Brussels should not be able to stop national authorities demanding banks hold more capital than levels set in the EU-wide capital requirements directive. The European Commission, the EU's top financial regulator, has countered this case for more national discretion with a strongly worded 10-page informal paper, laying out how it believes the UK's preferred system could damage the single market, hurt growth and unfairly disadvantage foreign banks when raising funds. More provocative still are sections arguing that eastern Europe - a key swing constituency in the diplomatic fight to build a majority of member states - would suffer most when big banks respond to higher capital requirements by pulling credit from lower priority markets. The documents, both obtained by the Financial Times, underscore the high stakes fight over the Commission's proposal, which aims to enact the internationally agreed Basel III rules. Diplomats say negotiations are deadlocked, with two unwavering camps wielding sufficient votes to block a deal, but without a majority to drive through the legislation. "This flexibility issue is the black hole sucking out all the energy," said one diplomat of the talks. Sweden, the Netherlands, Hungary and the Czech Republic are among those arguing for more flexibility, while French-led backers of tighter controls include Germany, Italy and Finland. The issue is so sensitive it is being elevated to finance ministers, who are expected to address it at an extra meeting in May. EU officials argue a "maximum harmonisation" approach - giving national authorities some flexibility within a minimum and maximum level of capital - is essential to creating a "single rule book" for banks across Europe. George Osborne, the UK chancellor, is adamantly opposed because it curtails Britain's ability to protect its taxpayers and limits the ability of the UK Financial Policy Committee, a new regulator, to deflate economic bubbles. British officials believe the rules also prevent regulators raising capital levels across the board for UK retail banks, as envisaged in the Vickers reforms. Brussels recognises some flexibility is required. But EU officials say the exercise of national powers with pan-European consequences must be handled through a European body. One concern in the Commission paper is that banks would respond to higher requirements by cutting their loan books, a process known as deleveraging. The paper argues this would hit eastern Europe hardest as banks "repatriate" capital from branches. "It is difficult to underestimate the importance of unilateral...flexibility on these member states," the Commission paper states. Higher requirements in some states, known as gold-plating, could also lead to slashed lending in other parts of Europe because it would "raise market expectations for banks from other member states to meet similar requirements," the Commission adds. The full and unfettered exercise of national macro-prudential measures could undermine the broader EU growth strategy. By contrast Mr Draghi's letter backs "flexibility in the set of available policy tools" and argues that raising capital levels can have "positive externalities." It also rejects the proposal for the Commission being given the power to decide when capital levels can be raised to stave off a crisis. "Tightening calibrations imposes short-term costs also on initiating member states, with positive stability externalities across the union," the letter states. That calls for ex-ante exchange of information and co-ordination, rather than for an authorisation procedure by a European body. Denmark, which holds the EU rotating presidency, has put forward three compromise texts to bridge the divide over flexibility. The latest, seen by the FT, introduces a double lock system where other member states must give permission if a nation wants to raise capital levels in certain circumstances. These compromises, however, fall short of UK demands and have failed to end the stand-off. The compromise texts also carry through contentious provisions on minimum capital calculations that help some German and French banks. Britain argues the "carve-outs" break the Basel accord.