Banks Whinge About Tougher EU Regulations to Reduce Too Big to Fail Risk

The Financial Times’ lead story, EU to retaliate against US bank capital rules, depicts banks as victims of a regulatory one-upsmanship. Amusingly, the article does its best to undeplay that the US rules were intended to improve bank safety and the so-called “retaliatory” measures would also have that effect.

In reality, the US rules, which were created as part of Dodd-Frank implementation, seek to address what has become a major impediment to solving the Too Big to Fail problem: that banks live internationally but die nationally. Bankruptcy and bank resolution take place in particular legal jurisdictions. But rather than require banks to have operations in each country that complied with local rules that were then part of a holding company structure, banks were permitted to operate under a “home-host” system. As far as safety and capital adequacy were concerned, the bank would be regulated by its home country regulators. That meant it could keep all its regulatory capital there. The regulators in the “host” countries could call the regulators in the home country and ask them to make the mother ship send capital to the operations in their country if they thought it was too risky. But that was a rare event.

Banks liked this system because it allowed them to move funds around the world far more freely. But it also resulted in the home country doing better if things got ugly. Remember the old saying that possession is 90% of the law. When Lehman failed, it had swept money from its UK operations into the US. One of the bones of contention in the bankruptcy proceedings was that there were some instances where US and UK courts issued conflicting rulings. The US judge, James Peck, was widely seen by jurists as having favored US creditors to a degree not previously seen in major international bankruptcies. Some thought that would lead to changes in UK or European regulations to protect the interests of investors in their countries.

But the interest of banks is more important. In the wake of the crisis, even though the US took only partial measures to make big banks less dangerous to the public at large, it still went further than European regulators did, particularly in requiring US banks to have higher capital levels. While I must confess to not knowing the byplay of how the Fed’s enhanced prudential standards came about, it’s not hard to imagine US banks pressing for the any new requirements to apply to foreign banks so as to prevent them from having a competitive advantage by being subject to weaker home-country capital standards.

The Financial Times story curiously neglects to mention that the new US rules are meant to deal with “too big to fail” banks, and apply only to banks with $50 billion or more in US non-branch, non agency assets. The foreign bank must form an “intermediate holding company” for these operations which is subject to US “enhanced prudential standards,” which included stress testing, the US version of Basel III, and liquidity and risk management requirements. And the various exams and requirements of the intermediate holding company assume no parent company support.

These rules were announced in 2014 and foreign banks were required to have formed their intermediate holding company operations and moved the relevant entities, such as a US bank holding company and broker-dealer units, into it, and start complying with most enhanced prudential standards by July 1, 2016. So it seems a bit odd for the EU to be “retaliating” now to rules announced over two years ago that have been in effect for months. But per the Financial Times:

Brussels is proposing to tighten its grip over overseas banks operating in the EU in a tit-for-tat step against the US that will raise costs for big foreign lenders and potentially hurt the City of London after Brexit…

If adopted into EU law, the commission’s proposals would force US investment banks such as Goldman Sachs and JPMorgan to have additional capital and liquidity in the EU so their subsidiaries can better withstand a crisis and be separately wound up if needed by European authorities.

The counterblow from Brussels, slipped into late drafts of the proposal, will be welcomed by European banks that have been complaining about an unlevel playing field with their US rivals. But it underlines the accelerating trend towards further fragmentation in financial rules, as jurisdictions assert control even at the risk of duplicating international requirements.

Although EU officials insist the proposal was drafted without Brexit in mind, the reforms would potentially affect London as a non-EU financial centre. The proposal could add costs and complexity to UK-based banks by forcing them to establish a separate pool of capital in the EU after the country leaves the bloc.

Has the pink paper been imbibing a wee too much Brexit propaganda? While annoyance with the US no doubt played a role, it’s hard not to see the specific timing (“slipped into late drafts of the proposal”) as related to Brexit.

And get a load of this:

Most bankers are reluctant to hold multiple pools of capital around the world, overseen by different regulators, which they see as more inefficient than a centrally managed pot set by their home authority. The need for a separately capitalised holding company in Frankfurt, for instance, would make London less attractive as a headquarters for European operations.

Yes, “inefficient” is a feature, not a bug. Pro-safety features, such as the redundancy of having two lungs and two kidneys, is less efficient than having only one. And balkanizing operations internally is a way to reduce overconnectedness, or what systems engineers call tight coupling. In his book A Demon of Our Own Design, Richard Bookstaber stressed that in order to reduce systemic risk, it was critical to reduce the tight coupling first. Otherwise, measures intended to reduce risk typically wound up increasing it.

So whatever the true cause, this EU “retaliation” is a development sorely to be wished, unless you work for a TBTF bank. And as Lambert pointed out, developments like this confirm that the World According to Davos Man, that of frictionless movement of capital and people, or at least those of the very rich, is seeing a reversal. Whether this is a short-term setback or a trend remains to be seen.

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  1. Larry

    Great summary Yves. I loved the analogy of organ redundancy, I’m definitely using that in future arguments!

    1. Vatch

      Apparently that’s how British people spell it. I don’t know how they pronounce it, though. My understanding is that “Saint John” is, at least in some contexts, pronounced “Sin Jin”, and “Magdalen” is pronounced “Maudlin”. For all I know, the British pronunciation of “Whinge” might be “Coatimundi”. Or it might even be “Whine”.

      1. ChrisPacific

        Rhymes with “singe” or “binge”. It’s actually a different word but means almost the same thing, except that “whine” refers more to tone and “whinge” to content.

  2. ChrisPacific

    What exactly does the FT mean by “US” in this story? Do they mean the taxpaying US population as represented by their elected government? If so, then the EU is doing the US a favor (arguably long overdue) by making it less likely that banks will be able to loot US taxpayers to make good on overseas losses in a crisis.

    The fact that the FT is instead presenting this as an escalation in some kind of trade war suggests that by “US” they really mean the collective interests of the group of large banks headquartered in the US. Neoliberalism would of course have us believe that they are the same thing, but nobody really believes that any more.

  3. RBHoughton

    The EU is in the disastrous position of having agreed to an entirely independent central bank. The supporters got that approved by using a single dodgy bit of research that suggested an independent bank would be more effective against inflation.

    Since then the ECB has looked after its friends and told the rest of the continent to go play with itself. The recovery of parliamentary control is one of the important changes that might prevent the EU falling apart.

    As usual with human institutions the central bankers would rather bring down civilization than one of their own so it going to take a Caesar, Charlemagne or Napoleon to save the EU from partition.

    Don’t understand the protest of inefficiency. Capital is capital wherever its held. Is the banks’ concern that they have already hypothecated their capital in the home market and cannot readily transfer it elsewhere?

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