Thursday, May 27, 2010

Europe cannot agree with itself, let alone the US on financial market reform

By Michael Prowse

If Tim Geithner, US Treasury Secretary, did any blunt talking in Europe this week, it was strictly reserved for off-the-record meetings. In public he was as diplomatic as he was optimistic. He failed to chide Germany for not adopting more expansionary macroeconomic policies and claimed that the US and Europe are “in a very good position to reach agreement on a global framework to implement common rules for regulating financial institutions”.

If this were true, we could all sit back and relax. But actual events suggest caution. In the first place, there is no such thing, yet, as a common European position on financial regulation, let alone an agreement between Europe and the US.

Secondly, the White House and Congress have pressed ahead with legislative reform for Wall Street without paying much attention to the competitive distortions that will arise globally if Europe fails to enact similar reforms. Although the US Congress deserves credit for grappling with these complex issues while other legislatures sit on the sidelines, the debate in Washington is depressingly insular. As so often before, US law-makers are behaving as though globalization were a fiction and US financial markets were entirely insulated from similar markets elsewhere.

There are good reasons why Europe has been unable to act as quickly as the US. The responsibilities of the European Commission – the EU’s executive arm – have not traditionally included financial or banking regulation. Until the recent crisis, most national governments regarded financial regulation as a purely domestic matter – regardless of the obvious cross-border spill-over effects. The new Conservative-led British coalition government is likely strenuously to resist any attempt by Brussels to impose tough regulations on the City of London.

The timing of the recent British general election also acted to delay financial reform. It was not in the interests of the outgoing Labour government to launch ambitious legislation ahead of an election it expected to lose. The Conservative-led coalition, meanwhile, is still finding its feet.

To date tentative steps to reform financial markets in Europe have generated controversy rather than consensus. Germany’s unilateral announcement of a ban on “naked” short selling (naked because traders place bets on securities which they do not own) provoked irritation among both its fellow EU members and the US. Undeterred Berlin this week published a draft law expanding the ban to all shares with a primary listing in Germany, as well as government bonds issued by eurozone countries. It also intends to ban naked short selling of the euro and the use of credit default swaps to bet against European government bonds.

Germany deserves credit for addressing some of the market practices that exacerbated the Greek debt crisis. By getting out front on this issue, it is putting pressure on the UK and other member states to clarify their own position. The European Commission appears broadly to support the thrust of the German measures but argues that such reforms can be effective only if adopted throughout Europe. The Commission is to present its own proposals on short selling in two weeks. But new laws might not take effect until 2013 – an unacceptably slow timetable by US standards.

The other talking point in Europe is the Commission’s proposal to tax banks, unveiled on Wednesday by Mr Barnier, the internal market commissioner. He wants banks “to contribute to a fund designed to manage bank failure, protect financial stability and limit contagion”. The idea is that the creation of a network of national funds would be a first step towards more centralised governance of the European banking sector – ultimately the plan is for a single EU-wide fund to help banks in crisis no matter where they are located in the EU. The Barnier plan will be discussed at an EU summit next month ahead of the G 20 meeting in Toronto at the end of June.

Britain and France, however, immediately rejected the plan, arguing it would create a “moral hazard”. In London officials warned that banks would regard the levy as an insurance premium which would entitle them to a bailout if they got into trouble. George Osborne, the new British finance minister, is planning a bank levy of his own, but it has nothing to do with financial regulation: he just wants to boost general tax revenue. In Brussels, the risk of moral hazard is understood, but Mr Barnier thinks it would be unfair if taxpayers were asked to bear the burden of future bailouts.

The US view is that European governments are losing sight of the big picture. Last year the US Treasury subjected big US banks to “stress tests” and forced those that looked vulnerable to raise capital. This helped spur economic recovery by boosting investor confidence. US officials argue that European regulators should concentrate on stress tests and capital raising rather than new taxes on banks. While in China, Sheila Blair, the FDIC chairman, told Bloomberg that European regulators ought to force their banks to hold more capital to help stabilise financial markets. European governments, meanwhile, justify inaction by arguing they are waiting on the outcome of the “Basel III” discussions on capital requirements, which will apply internationally.

US officials are uneasy because European nations have done so little to address the underlying causes of the banking crisis. They fear contagion if Europe suffers future banking crises. The unease is reciprocated but on different grounds: European officials complain that American law-makers have rushed to enact reforms without properly thinking through the consequences. For instance, many Europeans are worried by the Senate provision that forces banks to spin off their derivatives desks – since they frequently have a “one stop shopping” banking culture. Many also dislike the Senate’s embrace of the “Volcker rule” – the ban on proprietary trading.

In practice, both worries are probably overstated: Blanche Lincoln’s amendment on derivatives is likely to be watered down during the reconciliation process since both Barney Frank in the House and Christopher Dodd in the Senate favour greater flexibility. And the Senate bill already creates wiggle room on proprietary trading since it allows regulators to amend or reject the provision if future study shows that it has adverse effects on financial institutions.

I will assess the pros and cons of the US approach to financial market reform in a future blog. Suffice it for now to say that the focus of much European criticism is misplaced. The biggest shortcoming of the bills now to be reconciled is that they do not convincingly address the issue that many economists regard as pivotal to the crisis: the fact that many of the most powerful and diversified financial institutions have a bias towards risk-taking because they know they are too big to be allowed to fail, and because they have access to deposits which are federally insured.

The Obama administration’s assumption – echoed by the House and Senate - is that the basic institutional structure of Wall Street is sound. The problem was simply inadequate capital and inadequate regulation. But if the fundamental problem is a chronic bias towards risk, these reforms may not prevent the next crisis – which regulators will likely miss because the strains will emerge in a new and unexpected way – just as they did in 2007.

Will the European regulatory tortoise ultimately overtake the American hare and implement more coherent reforms of the financial sector? It seems unlikely because Europe will be unwilling to put itself at a competitive disadvantage to the US by doing more to restrain risk-taking. For instance, in Britain, the new government is setting up a commission to study whether big financial companies should be broken up to ensure they are not too big to fail. But even if the commission recommends dismemberment, it will never happen unless the US enacts similar reforms.

The danger is thus that whatever emerges from reconciliation in Washington will set a ceiling rather than a floor for financial regulation in the rest of the world. The task for the G 20 next month is to prevent this happening.

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