Weakness in Europe's Banks Spells Trouble for the U.S.

The fifth anniversary of the Dodd-Frank Act has occasioned vigorous debate about whether the law has made banks safer. To my mind, it is highly fortunate that U.S. bank regulators have overcome significant opposition from some politicians and bank lobbyists to finalize key rules pertaining to banks' capital levels, resolution plans and ability to weather a crisis. These regulations should help decrease the likelihood of another round of big-bank bailouts.

However, strengthened U.S. regulations will not insulate U.S. taxpayers if banks in other countries lack the risk management and capital levels to withstand unexpected losses. U.S. banks are extremely interconnected with foreign banks, and the safety and soundness of banks abroad should be cause for serious concern.

U.S. banks are especially sensitive to risks in the United Kingdom and continental Europe. Our large banks conduct numerous transactions with European banks, and a number of U.K. and European banks have significant operations in the U.S. According to Federal Financial Institutions Examination Council data, 90% of U.S. banks' foreign exposures in the form of securities and derivatives trading or loans are to banks, corporations, and the government in the U.K. Most of the remaining 10% are exposures to continental Europe and Japan.

Unfortunately, U.K. and European banks' profits and safety continue to be challenged by economic troubles on the continent and market volatility. The constant possibility that Greece could leave the euro zone and that the U.K. might consider leaving the European Union are particularly destabilizing factors.

It's clear that European banks need to do a lot more work to ensure their stability. Late last year, the Basel Committee found that the European Union is not fully compliant with six of the 14 components of Basel III. Yet rather than encourage European banks to improve their ability to survive credit or market shocks, Jonathan Hill, an EU commissioner for financial services, is trying to weaken European banks' compliance with Basel III bank capital rules to encourage them to lend.

European banks, like many in the U.S., are already decreasing credit standards when making loans. Weaker Basel rules could therefore adversely impact any bank that is counterparty to transactions with European banks, and U.S. banks might be encouraged to engage in regulatory arbitrage by moving assets to Europe.

Because U.S. bank regulators are members of the Basel Committee, they can voice their concerns about the safety of U.K. and European banks. But they do not have the power to examine the condition of foreign banks outside U.S. borders. The most meaningful tool available to regulators who seek to protect U.S. banks and taxpayers from the vacillations of their foreign counterparts is their ability to impose tough requirements on foreign banks with U.S. units.

Because European banks are struggling with earnings, regulatory capital and transparency, politicians and financial reformers in the U.S. should be on guard about Sen. Richard Shelby's efforts to raise the threshold for systemically important banks from $50 billion in assets all the way to $500 billion. If this proposal were to pass, European banks including BBVA, Deutsche Bank, HSBC and Banco Santander could escape in-depth regulatory scrutiny. These banks all conduct significant lending, investment banking, and derivatives transactions in the U.S. and are interwoven with the U.S. economy.

Of these banks, the two that should be of most concern are Deutsche Bank and HSBC. Deutsche has relied heavily on debt markets for its revenues. With low interest rates prevailing in the U.S. and Europe, it will be difficult for Deutsche to maintain profitability and remain sufficiently capitalized to sustain unexpected losses. Additionally, the bank remains in the spotlight due to managerial and legal challenges. According to a German regulator's recent report, Deutsche continues to struggle with weak operational risk management, as evidenced by its role in market rate-rigging scandals.

For its part, HSBC has such a long list of global money laundering, terrorism financing and rate-rigging scandals that it's hard not to find a country where it is paying numerous fines and spending millions to hire compliance officers and auditors, all in the hopes of improving its operational risk management.

Shelby's proposal would weaken U.S. bank regulators' right to impose enhanced capital, risk management, and stress-testing requirements on these and other foreign institutions. If their conditions worsen, foreign banks might dip into funds from their U.S. subsidiaries, negatively affecting the U.S. economy. Yet if the U.S. subsidiaries' capital were to weaken, there is no guarantee that European parent companies will be able to rescue their offspring.

Government funds have already been used once to rescue foreign banks during the 2008 crisis. It would be a significant setback for Americans if we allow politicians to weaken regulations for big banks with a presence on our shores. While politicians like Sen. Shelby come and go, their shortsightedness can have painful repercussions that last for many years.

Mayra Rodríguez Valladares is managing principal at MRV Associates, a capital markets and
financial regulatory consulting and training firm in New York. On Twitter, she is @MRVAssociates.