US and Europe lawmakers disagree over financial reform

Since the financial crisis began, lawmakers and politicians globally have stressed that any reform of the banking sector should be the product of international co-operation. Recently, however, cracks have started to appear, with US and European policymakers going down different paths towards regulatory reform.

One of the clearest messages to emerge from the G-20 summit in Pittsburgh in September 2009 was that the regulatory system for banks and other financial firms must be changed to rein in the excesses perceived to have caused the financial crisis.

Just as important as the message was the method: action would be taken on a global basis with the Financial Stability Board (FSB) – an all-powerful collective of international regulators, formed out of the ashes of the Financial Stability Forum – appointed to monitor the progress of full and consistent implementation of regulatory reform.

“We are committed to take action at the national and international level to raise standards together so that our national authorities implement global standards consistently in a way that ensures a level playing field and avoids fragmentation of markets, protectionism, and regulatory arbitrage,” stated the leaders of the G-20 countries at the summit.

However, in February, Dominic Strauss-Kahn, managing director of the International Monetary Fund, penned an article in the Financial Times reminding the world about the imperative of international efforts to co-ordinate reform. As one veteran observer of regulatory initiatives notes: “Strauss-Kahn knows exactly what is going on in private discussions. If he was moved to make this statement now, he knows co-ordination is in real danger of failing”.

Failure to co-ordinate reforms could result in an additional layer of regulatory complexity for international banks, making it harder for them to objectively assess their financial strength. Moreover, nationally focused rather than international reforms may not address the systemic risk revealed by the financial crisis. Indeed, some changes to domestic regulations could hinder efforts to create a more stable financial system.

Additionally, the differing objectives of national regulators (and the differing severity of bank-related solutions they plan to introduce) raise the potential for regulatory arbitrage. At the very least, the emphasis on national solutions could create a less level playing field.

Why co-ordination matters

While the origins of the financial crisis – the US subprime mortgage market – are well known, the precise causes are both myriad and complex. Nevertheless, in the catalogue of possible causal factors, regulatory arbitrage is not on everyone’s short list.

“There has always been regulatory arbitrage and it was not a huge contributory factor in the financial crisis,” says Richard Reid, director of research at the International Centre for Financial Regulation (ICFR), a body that promotes dialogue about regulation.

However, in the past 15 years the speed of growth of the financial services sector has outpaced the ability of regulators to monitor it. “At the same time, the leitmotif of this period was light touch regulation,” adds Reid. The combination of these factors was certainly a contributory factor to the severity of the crisis.

Alessandra Mongiardino, senior credit officer and head of the risk management team at Moody’s Investors Service in London, is more explicit about the contribution of regulatory arbitrage to the financial crisis. She illustrates an important example of the phenomenon: “In the past, there were different definitions of capital, with many national discretions related to the definition of capital and the calculation of risk-weighted assets,” she says. “That made it easy for banks to exploit regulatory arbitrage and ultimately made it hard for investors to compare, for example, tier 1 capital ratios in a meaningful way.”

The lack of transparency surrounding financial strength was an important element in the financial crisis, according to Mongiardino. “Common rules and consistent implementation are a key requirement for a more stable framework,” she says. “A more stable international financial system needs a common rulebook.” One crucial component of this rulebook is that large banks need to be dealt with according to international principles.

The alternative – country-specific regulatory change – is problematic, according to Luis Maglanoc, global head of credit research at UniCredit. “To cite the IMF’s example, a number of countries have decided that foreign banks, even if they are operating as foreign branches, should maintain higher levels of liquidity locally to withstand a potential freeze in their access to local funding,” he says. “On the face of it, this is prudent. But major banks manage their funding and lending risks globally. If banks have to lock up pools of liquidity in every jurisdiction, their capacity for intermediating capital across borders could fall, and their charges for doing so rise, to the detriment of the world economy.”

Reducing regulatory arbitrage gained political support at the G-20 summit in Pittsburgh. Which begs the question: why has the process faltered? 

Reid at the ICFR confirms there has been “a definite wobble” in co-ordination efforts since the turn of the year. “The political momentum that emerged from the G-20 has waned, while resistance from the financial industry has increased,” he says. “The reasons for this wobble are simple: when co-ordination of regulatory reform was being discussed in 2009 the world remained in the teeth of the financial crisis. Now the immediacy of the problem has disappeared. At the same time, banks have been emboldened by, in many cases, their return to profitability.”

Thomas Pax, head of the US regulatory group at Clifford Chance in Washington DC has a different take on the situation. “In order to say the co-ordination of regulatory reform has broken down, one has to assume there had been something in place previously,” he says. “The reality is that G-20 was a statement of broad principles that individuals then went off and interpreted in a national context, often with significantly different results.”

For example, the G-20 principle that systemically significant hedge funds should be regulated has resulted in the US regulating advisors but introducing no meaningful regulations on funds themselves. “In contrast, the Alternative Investment Fund Managers Directive in Europe is a broad measure with significant consequences for a wide range of investment activities, including a substantial increase in compliance costs,” says Pax.

As Mongiardino at Moody’s notes, there is an incentive for national authorities to push ahead with their own reforms and hope others will follow. “But if everyone does that there is no consistency,” she says. “The trouble is that international co-ordination is very difficult and takes time, but many regulators feel under pressure to address these issues quickly.”

According to Reid, that pressure is the real reason why attempts at consensus have failed. “The nuts and bolts of minimising regulatory arbitrage are hugely complex. While it has been possible to get a broad architecture, results from the G-20/FSB process will be a long time coming,” he says. Meanwhile, the reality of everyday politics continues. “There is inevitably a tension between the global aspirations of the G-20 and the day-to-day demands of domestic politics. For example, in the US the setback to Obama over his healthcare proposals was swiftly followed by the announcement of the Volcker rule.”

Dancing the Volcker

The Volcker rule – a surprise measure announced by President Obama on January 21 and named after former Federal Reserve chairman Paul Volcker – is perhaps the most graphic example of the challenges facing international co-ordination of regulatory reform. “It could be seen that the Volcker initiative represents a failure of the US to co-ordinate reform,” says Maglanoc at UniCredit.

The Volcker rule primarily affects investment banks and attempts to address the crucial ‘too big to fail’ problem that has troubled regulators worldwide. It proposes new limits on banks’ proprietary or own-account trading and discourages speculative activity unrelated to essential banking services.

Under the first restriction, banks would no longer be allowed to own, sponsor or invest in hedge funds or private equity funds. Furthermore, the use of proprietary trading operations on an institution’s own account would also be prohibited. The second element of the rule would prevent further consolidation of the US financial system, placing broader limits on how large an institution’s market share of liabilities could grow, supplementing existing caps on the market share of deposits.

“The issues that Volcker is designed to address – excessive risk-taking by banks – are primarily of importance for US banks,” says Maglanoc. “In much of the rest of the world, particularly in Europe, the universal model of banking prevails and excessive risk-taking is more limited.”

To be sure, US investment banks are the world’s largest and also take some of the biggest risks. According to JP Morgan estimates, a selection of global investment banks it analyses (Credit Suisse, Deutsche Bank, Goldman Sachs, Morgan Stanley and UBS) were already facing a 6% fall in earnings per share as a result of Representative Barney Frank’s proposals to the House Financial Services Committee on OTC derivatives and market risk requirements. “Obama’s proposals have a bigger impact on earnings with a -15% EPS dilution on average in 2011,” says Kian Abouhossein, banking analyst at JP Morgan.

Abouhossein adds that Goldman Sachs is most under threat due to “its principal investments business and high fixed income gearing, with a potential total negative 27% EPS impact in 2011” from the twin sets of proposals. However, in second place as a result of its high fixed income profit generation is Deutsche Bank, an institution that, while a formidable force in global investment banking, is also the model of a European-style universal bank. Clearly a rule designed for the US is going to have significant implications on some of Europe’s most systemically important banks. Therefore it only seems appropriate that regulators in Europe should have been consulted.

Instead, the Obama administration failed to talk to other international regulators about its plans, despite the Federal Reserve and other regulatory officials meeting with their peers just weeks before: in early January there was a series of meetings of the supervisory board of the Basel Committee, the FSB and the Joint Forum (comprising the Basel Committee, the International Organization of Securities Commissions and the International Association of Insurance Supervisors). At none of these meetings were the prospects of a major reform – at least one outside the areas set out by the G-20 as priorities – raised.

Philosophical differences

The regulatory approaches taken by Europe and the US to date would appear to indicate a difference in philosophy. “Generally, Europe is taking a less legalistic approach in reforming regulation,” explains Tim Plews, joint head of Clifford Chance’s London finance and capital markets practice. “Of course, there is irritation that some European banks bought toxic debt but the goal of regulators appears to be to discourage future stupidity through capital charges – a method of modifying behaviour that is more likely to prove effective in the long term than legislation prohibiting certain activities, which can often be circumvented by lawyers.”

UniCredit’s Maglanoc, meanwhile, believes that regional differences are both necessary and inevitable. “There is a legitimate argument for saying banks need to be able to take risk to act as an effective intermediary,” he says. “However, the crucial issue is one of volume. In the US, the scale of risk-taking activities at some banks – Goldman Sachs, for example, which effectively operates as a giant hedge fund – is such that it is not possible to apply the same sort of constraints.”

By contrast, most regulators in Europe recognise that such activities can be controlled by stricter calibration of capital requirements on risk-weighted assets or on trading books – requiring banks to allocate three times more capital to trading books under Basel II, for example. Maglanoc says the lower levels of risk-taking among European banks means that any risk can be effectively managed by measures such as limits on large exposures; improving the quality of bank capital; a new framework for liquidity risk; the introduction of leverage ratios; capital buffers; forward-looking provisioning; as well as the Basel II Pillar 2 (supervisory review process) and Pillar 3 (market discipline through transparency and risk disclosure).

At first glance it would take an incurable optimist to see any hope of Basel accords being a foundation for global regulatory reform. “Some of the US regulators, such as the Federal Deposit Insurance Corporation, are vocally opposed to some of the principles of Basel II, including the use of internal models,” says Mongiardino at Moody’s. “This has weighed on the lagged implementation of the Basel II framework in the US.”

Indeed, at the same time that the US is preparing to begin widespread implementation of Basel II, Europe is moving towards what has been dubbed Basel III, which combines a micro prudential focus with macro prudential initiatives, such as the creation of the European Systemic Risk Board and the European Banking Authority. Basel III proposals also significantly change bank capital regulations, possibly compelling firms to raise huge amounts of capital to meet tier 1 requirements: Credit Suisse estimates European banks might need an additional €139 billion under the proposals.

Nevertheless, there is some hope the Basel accord, because of its lack of political interference, could prove a key component of regulatory co-ordination. “Certainly the consensual way in which the Basel Committee makes decisions has greater theoretical potential to deliver results than legislation,” says Pax at Clifford Chance.

Moreover, Basel has an authority that other co-ordination bodies lack. “Nominally the G-20 and the FSB have responsibility for co-ordination, but in practice the real nitty-gritty of global-scale reform is vested in the Basel Committee,” says Maglanoc at UniCredit.

Pax says the implementation of Basel II in the US “will be a good indication of the potential for the Basel Committee to bring the world closer together in reform”. He adds: “It remains to be seen how and when Basel II will be implemented given innumerable delays and tests so far. With Basel III on the way for the rest of the world, there could be further debate in the US.”

The new world of banking

Ultimately, the raft of regulatory initiatives worldwide will make banking more boring, safer and less profitable. Higher capital and liquidity requirements will increase the cost of capital and reduce margins, while operating costs will rise to comply with what Maglanoc describes as a “tsunami of regulations”, which will ultimately decrease profits.

On the positive side, though, “well-thought-out and strictly implemented regulation will enhance risk management and reduce the incentive for banks to do speculative and risky business,” says Maglanoc.

In the next two years, as regulatory capital increases are introduced, all banks will be forced to re-examine their business models to see if they are sustainable. “The role of banks will be squeezed and other financial institutions such as insurers may step into niches abandoned by banks,” says Reid at the ICFR. Similarly, Plews at Clifford Chance says that “a lot of value-added activities will be spun out of major banks in the coming years” as they consider the risk-adjusted costs and returns of some previously attractive businesses.

Despite differing regulations in the US and Europe, Reid says it is difficult to draw a geographical distinction in how banks will be affected. “Within both regions some banks will be more affected than others,” he says. “While it is easy to assume banks will end up following a standard model, such a move will be opposed because it creates increased risk.”


Combatting systemic risk: An interview with Viral Acharya, NYU

When Lehman Brothers filed for bankruptcy on September 15, 2008, it set off a chain reaction around the world. The collapse of the Wall Street giant starkly illustrated the danger posed to the wider markets by the failure of complex, systemically important institutions.

Reducing the risks posed by institutions dubbed ‘too big to fail’ has been a cornerstone of proposed financial sector reforms across the globe in the wake of the crisis. For Viral Acharya, professor of finance at New York University’s Stern School of Business, resolving the issue is crucial to restoring the stability of the financial system; even though it represents a daunting challenge for regulators. 

“Systemic risk is the key issue, and there are several ways of addressing it,” he says. “Do you try to enforce higher capital requirements for systemically important institutions or do you tax them in some way? No matter what you try, however, there will always be some risk you have not been able to anticipate fully or contain, because leverage and risks are difficult to pin down exactly.”

According to Acharya, any proposed regulations to tackle systemic risk must remove the incentives for companies to become too big to fail.

“The private incentives for the financial sector to deal with systemic risk are poor. Financial institutions know that if many of them are failing at the same time, traditionally there has been a bailout, or they get access to cheaper financing. To me, it seems fixing the incentive issue means fixing the issue of systemic risk.”

Size caps have been mooted as a possible fix, but Acharya argues that complexity, rather than size, is the crucial factor when it comes to gauging systemic risk. “Think about Fidelity: it’s a huge financial institution, but there’s no systemic risk, no leverage,” he says. “Even if you are small, you could potentially end up being systemic. Northern Rock was not that large, but it failed in the crisis.”

Taxing times

Another possible solution, a systemic risk tax, would essentially impose a charge on assets funded with leverage. Acharya views that as a step in the right direction, but says its effectiveness depends on the nature of the assets.

“If we’re talking about a Treasury or money market fund, the assets may be funded by leverage but are basically safe, so don’t pose a systemic risk. Conversely, there are other assets that are more correlated with the economic cycle. A systemic risk tax is a step in the right direction but it could be improved.”

When Lehman Brothers folded, the global nature of its business meant banks in all regions were affected. Consequently, Acharya argues there will have to be international co-ordination on legislation if the systemic risk posed by the failure of large conglomerates is to be properly addressed.

“When [regulators] are thinking about living wills or resolution plans, they must come up with mechanisms that are sufficiently elaborate so that it is clear how you deal with an international financial conglomerate. Clearly the Federal Reserve cannot resolve a failed US bank that has Asian branches without co-ordinating with the regulators in those countries.”

Despite the G-20’s declaration that international co-ordination will be at the core of regulatory reform, Acharya is concerned that debates on a domestic level are holding up this process.

“In the US there is a lot of talk and different proposals, but nothing concrete has happened. If we were to have another unexpected failure – or even stress – at a large systemic institution we really haven’t done anything to contain the damage other than know the government and the Fed can probably backstop some things. Given what happened with Lehman, I would have thought some of the resolution issues might have been handled with greater alacrity,” he says.

If domestic problems are ironed out, however, effective internationally co-ordinated regulation is possible. Acharya sees the development of Basel II as a template. “I’m actually more hopeful than many people. It might not have been the right regulation, but at least Basel II was a process that different countries stuck by. I think some standard like that might emerge from the current situation.”