A war of words has broken out between the Treasury Department and the EU over proposed EU financial services regulations. The first salvo in this dispute occurred earlier this week, when, as reported in the Guardian, American banks were excluded from the sovereign bond market, which means new issues (they obviously cannot be prohibited from making secondary trades in an OTC market). This is seen as punishment for their role in helping various states evade EU rules on deficit spending via using currency swaps. But as the Guardian noted, the EU increasingly has broader concerns about the appropriateness of an Anglo Saxon finance model that looks predatory:
“Governments do not have the confidence that the excessive risk-taking culture of the big Wall Street banks has changed and they still cannot be trusted to put the stability of the financial system before profit,” said Arlene McCarthy, vice chair of the European parliament’s economic and monetary affairs committee. “It is no surprise therefore that governments are reluctant to do business with banks that have failed to learn the lesson of the crisis. The banks need to acknowledge the mistakes that were made and behave in an ethical way to regain the trust and confidence of governments.”
Yves here. Now despite the howls from the US (more on that shortly) this is not as unreasonable as it sounds to people conditioned to think that regulators have no business…..regulating. For instance, it standard operating procedure that when a defense contractor has violated certain rules, that it will be frozen out of the contracting process for a while, the length of exclusion depending on the seriousness of the misconduct. Similarly, foreign regulators have taken much more serious actions against US miscreants in the past (Citi was forced to shut down its private banking operations in Japan, which had a major focus of their business in that country, as a result of serious regulatory violations and resulting termination of licenses. That’s not a bug, that goes with the terrain in any regulated businesses). These firms operate with the sufferance of the state, and the state reserves the right to intervene if it does not like the behavior that results. Now there is an implicit obligation on the part of the state not to intervene capriciously, otherwise no one would take up these franchises to begin with.
The other reason this action is not as unreasonable as it is being seen in the US is that the EU operates on a principles based system, while our legal system is rules based. We have a peculiar notion here that if a business manages to weave its way through a legal thicket, or better yet, tear down rules that constrain behavior, then all is fair, no matter how fraudulent or predatory the behavior is by any common sense standard. That sort of posture does not go over very well in a principles based regime.
So now go back and re-read the excerpt above. The right response, from the EU perspective, is for the US firms to roll over and show their bellies, which means apologize in public and private, and make at least vague, better yet specific, promises not to do certain bad things again.
But Ed Harrison called correctly what the likely response would be, namely to escalate:
I would expect the U.S. bank lobby to pressure the Obama Administration into developing demarche communiqués at the State and Commerce Departments condemning this as a protectionist move. This is the type of work that State and Commerce does regularly on behalf of companies like Chiquita Brands International. The bank lobby is much more powerful. So, one should expect this to rise to an Ambassador-level talking point.
Yves here. What he did not anticipate was how quickly temperatures have risen. As this and other blogs noted, the EU is also considering restricting the reach of private equity funds, both their ability to make investments in Europe, and the ability of EU investors to put money in US funds.
The next step was Geithner issuing a letter contend that proposed EU regulations of that suggested that these proposals were discriminatory. While on paper that argument might appear sensible, it deliberately obscures a bigger reality: the way these firms operate, particularly the PE firm practice of using leverage, and the consequences of leverage (if you get it wrong, firms go bankrupt more so that if they had not borrowed, leading to unemployment) runs afoul of other government policies. This is a matter of sovereignity conflicting with an ideology that more open markets are ever and always better. You cannot have both in absolute form, and the EU is deciding to trade off one versus the other in a manner different than the US does.
Needless to say, the EU is not taking this lying down, and points out that some of the actions that Geither was taking aim at in his broadly-worded letter were in fact consistent with G-20 commitments:
A spokesman for Michel Barnier, the new EU internal market commissioner who is responsible for financial services regulation and to whom Mr Geithner addressed his concerns, said that the EU decision to act on hedge funds was in line with a G20 decision to reinforce transparency in the financial system.
He added that the new commissioner wanted to “work closely” with the US, to ensure “robust standards” in financial services.
Yves again. While this is all very entertaining, the focus on the tit-for-tat misses the elephant in the room: what the hell is Geithner doing lobbying for hedge funds and PE funds?
The Volcker rule makes clear that the US does not regard these as functions integral to the operation of a healthy financial system and deserving of backstopping. The vast majority of PE and hedge funds, in terms of their staffing, are small businesses. Since when do small businesses have the Treasury secretary going to bat for them in a major international spat (this is the lead story in the Financial Times right now, lest you have any doubt).
Follow the money. Its “change” and populist pre election branding to the contrary, Obama raised more money from the financial services industry than any previous Presidential candidate. And the procurer-in-chief, Rahm Emanuel, concentrated his impressive fund-raising efforts on hedge funds and private equity firms (see here, here, and here). They expect a handsome return on investment, and it sure looks like they are getting it.