Banking Regulation Heads Down Protectionist Path

Confusing crosscurrents are rippling through global financial supervision.

Consider these four recent moves: the Financial Stability Board agrees on ways to improve supervision of the world's largest banks; the Federal Deposit Insurance Corp. strikes a deal with the Bank of England on resolving troubled banks that operate in both countries; the Basel Committee on Banking Supervision dilutes tough international liquidity standards; and the Federal Reserve Board proposes a sweeping crackdown on foreign banks operating in the U.S.

So that's one instance of coordination, one of cooperation and one of trying to make it easier for everyone to get along counterbalanced by an example of circling the wagons.

That might make the Fed's move seem like the outlier; that regulators the world over are trying to work together to make the collective system safer.

But that's not what's happening. In fact, of those four actions, the one that says the most about trends in global supervision is the Fed's foreign-bank proposal.

"This isn't just one more set of ‘ring-fencing' ideas. … This is much more than that," says Charles Dallara, the managing director of the Institute of International Finance. "It cuts to the very heart of whether or not we can stabilize financial systems without basically drawing the blinds on our borders from a financial point of view."

Karen Shaw Petrou, managing partner of Federal Financial Analytics, says that's exactly the future she sees. "What this tells us about the harmonization of banking supervision is that it's a hopeless dream," Petrou says. "This ‘my way or the highway' approach is increasingly the way international bank regulation will be handled."

Indeed, global standards are giving way to an every-country-for-itself approach. Like the Fed, the Swiss and the British are exploring various paths to protect their institutions, depositors or creditors. And why not? Even when countries can agree, on international capital rules for example, adoption is sporadic and enforcement is worse.

But balkanized regulation leads to a balkanized industry, which translates into higher costs and higher prices, and ultimately a drag on growth.

Fed Gov. Jerome Powell raised this concern during the Fed's Dec. 14 open meeting when it voted to put the plan out for public comment. "The proposal, it seems to me, moves us down the road toward a more fragmented banking system, toward a more fragmented regulatory system," he said.

Powell asked what impact requiring foreign banking organizations to hold extra capital and liquidity at their U.S. units would have on world economic growth.

Mark Van Der Weide, a senior associate director in the Fed's supervision division, assured Powell that Fed staff members still think "harmonization of global regulatory standards is an important goal to achieve."

"We don't think this should be viewed as kind of a walking away by the Federal Reserve from that commitment to getting the core prudential standards for global banks the same or as similar as possible," he said.

Still, Van Der Weide made it clear that the Fed's higher priority is protecting the U.S. financial system. "What we concluded is that while getting those core prudential standards globally harmonized is a good thing, it's a necessary thing to do, it's not sufficient to protect the U.S. financial system," he said. "So we feel like … we need to have more capital and more liquidity for the U.S. operations" of foreign banks. 

The law firm Cleary Gottlieb tackled Powell's question more directly in an analysis of the proposal for its clients. Foreign regulators "may perceive that the Federal Reserve has abandoned the high road of cooperation in exchange for an ‘every nation for itself' policy," according to the law firm. "The Federal Reserve has made the judgment that the costs of its proposal would be outweighed by the perceived benefits for U.S. financial stability."

But the Fed could be wrong, and its attempt to protect U.S. interests could make the overall system weaker. For instance, foreign banks may decide that doing business in the U.S. isn't worth the extra effort, cost, etc. If they leave or significantly scale back their business, that would concentrate our markets even more, both for credit but, more important, for our capital markets.

Right now the OTC derivatives market is dominated by five U.S. banking companies and about the same number of foreign firms. If Deutsche Bank, Barclays, UBS and Credit Suisse trim their U.S. operations, that means firms like JPMorgan gain more market share. Reducing competition rarely improves financial stability.

I'm not criticizing what the Fed is proposing. Solid arguments can be made for nearly everything the Fed wants to do. Indeed, the Dodd-Frank Act requires the Fed to do something to get a tighter supervisory grip on foreign banking organizations.

But it's worth asking some questions to ensure that any steps taken to make the system safer don't inadvertently undermine its stability. That may sound counterintuitive, but safety and stability don't always move in lockstep. Safety measures impose costs.

"It's really a question about the balance between stability and efficiency," says Stefan Walter, the former secretary general of the Basel Committee who is now a principal in Ernst & Young's Global Banking and Capital Markets practice. "If everybody drove tanks," Walter says, "it would be extremely safe, but that's probably not the most efficient and effective way to get around."

His E&Y partner, Don Vangel, a former Fed supervisor, adds: "When you start prescribing governance structures, when you start trapping capital and liquidity, other things being equal, the system needs more than it would otherwise, and immobility of capital and liquidity is not necessarily a stabilizing thing."

Barb Rehm is American Banker's editor at large. She welcomes feedback to her column at Barbara.Rehm@SourceMedia.com. Follow her on Twitter at @barbrehm.