By Huw Jones

LONDON (Reuters) -European Union member states have backed a temporary watering down and two-year delay to 2025 for the final leg of the globally agreed Basel III bank capital rules, despite the ECB warning they risked “cracking the dyke” that protects stability.

EU states will now negotiate a final deal with the European Parliament in early 2023, with further changes possible.

“One of our main goals was to avoid impacts on European banks that could reduce their ability to finance the European economy,” Czech finance minister Zbynek Stanjura told a meeting of EU finance ministers on Tuesday.

Most of the Basel III, a set of tougher capital rules devised for banks after the global financial crisis more than a decade ago, have already been implemented.

“It shows once again our commitment to international standards and multilateral cooperation,” said Valdis Dombrovskis, executive vice president of the European Commission, the EU’s executive body.

Finance ministers for Germany and France said the package struck the “right balance”, with Spain adding that it reflected “idiosyncrasies” in Europe’s banking sector.

“This flexibility gives banks enough time to adjust to these new rules,” German finance minister Christian Lindner said.

European banks have lobbied hard for a temporary watering down of some of the remaining Basel III features, arguing they already hold enough capital and that higher requirements would crimp lending to the economy.

EU ministers agreed to delay the roll-out of the final rules until January, 2025 due to economic fallout from COVID-19.

The revised rules would give relief until 2032 to largely neutralise capital increases for some banks holding low-risk mortgages, but make it harder for investors to compare European banks with peers from elsewhere in the world, analysts said.

Based on a new “output floor” for determining capital levels, EU states which host banks headquartered elsewhere in the bloc can insist that part of group capital is held locally.

Smaller banks would benefit from simpler disclosure, and EU states pushed back against attempts at stricter EU harmonisation in ensuring that top bank staff are ‘fit and proper’.

Nuria Alvarez, analyst at Madrid-based brokerage Renta 4, said the long-flagged delay was positive for banks, but was already priced into markets.

“In 2025 we should be in a more normalised macro environment and the banks have time to adjust their balance sheets so that the impact of the measures is less onerous than it if they had to be implemented in 2023,” she added.

S&P said last year that diluted norms would not materially affect credit ratings given that banks’ buffers already exceeded minimum standards, and they could boost dividends and other payouts.

Markus Ferber, a German centre-right member of the European Parliament, said EU states took a “pragmatic step in the right direction” to tailor global rules that are a poor fit for Europe’s banks.

‘CRACKING THE DYKE’

EU states also watered down Commission proposals to toughen up requirements on branches of foreign banks in the bloc, easing pressure on them to open subsidiaries with the extra capital and EU supervision that brings.

Luxembourg said the move ensured an “open economy” with more diversified sources of funding for EU economies.

The watering down comes despite warnings last week from the European Central Bank, which regulates top euro zone lenders, and the bloc’s banking watchdog EBA, which said the bloc could fall foul of global rules.

EBA said in September that banks in the EU collectively need only a further 1.2 billion euros to meet Basel III in full by 2028.

But on Tuesday, ECB Vice President Luis de Guindos told ministers he was concerned about deviations from Basel III at a time when the EU economy faces risks.

“Each deviation may only appear as an isolated crack in the dyke protecting the banking system, but together these numerous cracks erode soundness and stability,” de Guindos said.

The Netherlands stressed that the temporary deviations must stay temporary.

The EU is ahead of Britain and the United States in setting out how it wants to implement the final leg of Basel III.

The Bank of England has said it will also begin implementing the rules from 2025, but that it will not match some of the easing being approved in the EU.

The BoE is likely to keep a close eye on what the Federal Reserve decides given the big presence of U.S. investment banks in London.

(Additional reporting by Jesus Aguado in Madrid, Editing by Alex Richardson, David Goodman, Ed Osmond and Tomasz Janowski)