Reining in the European Banks

The start of 2011 – what we might call Year 2 AG ("After Greece’s" debt crisis) – has brought good and bad news on the economic front. The bad news is that 2 AG is beginning with more or the same, with headlines about government debt and default, this time focused on Portugal and Spain.

The good news is that Europe continues to make steady progress in redesigning the architecture of the financial system that melted down during the economic crisis that began in 2008.

In the latest sign of progress, January saw the launch of four new supervisory agencies that will police Europe’s financial institutions and protect consumers and taxpayers. The four agencies include the European Banking Authority (EBA), European Insurance Authority (EIOPA), European Securities and Markets Authority (ESMA), and a European Systemic Risk Board (ESRB), chaired by the President of the European Central Bank that will monitor and warn of excessive risk in the financial system and economy.

The new EU regulators will have the power to ban trading in certain financial instruments, and to settle disagreements between national financial regulators. They also will be able to give direct instructions to banks and other financial actors in crisis situations and in cases where national regulators are in clear breach of EU rules. They will also draw up technical standards to be applied by national regulators.

These regulatory bodies are the centerpieces of the European Commission’s efforts to reform the financial industry in the wake of the crisis, and they will oversee the enforcement of other reforms that already have been passed or are in process.

"This is a very important result. We have the foundation of a new European supervision," said Michel Barnier, the European commissioner for the internal market, describing these as "the control tower and the radar screens" that the financial sector needs. "This is just a first step," he emphasized. "We will dispose of a framework in which the Commission will continue, brick by brick, piece by piece, to propose elements."

Various international bodies, especially the Group of 20, have been important forums for trying to coordinate a global approach to financial reform. The United States, from where the financial cancer initially spread, also has legislated reforms, the primary being the "Dodd-Frank Wall Street Reform and Consumer Protection Act." But America’s reforms have generally not been as comprehensive or as far-reaching as those in Europe, resulting in much frustration both in the U.S. and abroad.

Below is a scorecard in Europe and the U.S. on banking and financial reform.

1. Cash reserves for banks. Europe has led the way, via the Basel III process, in requiring banks to maintain higher levels of cash reserves as a cushion against investments that go bad. Basil III has called for a quadrupling of reserves, though some of the German banks have fought this and managed to delay the implementation. The U.S. has yet to make firm commitments, though they are likely to do so by the end of 2013.

2. Skin in the game. To prevent Goldman Sachs and others from creating investment vehicles that they know are designed to fail, Europe will require the packagers/originators of all asset-backed securities to retain at least 5% "skin in the game," meaning they must retain ownership of 5% of any securities they create. This will provide an incentive to be more careful as their own money will be at risk. The U.S. is requiring something similar, but its rules are much narrower, requiring 5% skin only for the sub-prime mortgage-backed securities.

3. Bonus crackdown. To address the negative role that remuneration practices played in encouraging risky investment behavior by executives, the EU has issued comprehensive new rules linking bonuses more closely to salaries, issuing bonuses in non-cash instruments such as company shares, and establishing a "claw-back" mechanism whereby bonuses can’t be collected for several years to ensure that current business practices don’t result in a future meltdown. Here, American controls remain mostly non-existent, beyond enhancing shareholders’ oversight role.

4.  Hedge fund crackdown. The EU has issued comprehensive new rules governing the structure, activities, marketing, capital and liquidity requirements for all hedge funds. U.S. rules are considerably more lax, requiring only that hedge funds register with the Security and Exchange Commission.

5. Derivatives/Volcker Rule. The big debate over the $600 trillion derivatives market – which is ten times larger than the GDP of the entire world – was whether derivatives and other types of speculative investments should be removed from commercial banks (which hold the deposits of thousands of individuals), since the huge amount of speculative investments represent a potential threat not only to individual banks but to the banking system itself. To counter this, the Volcker Rule called for partial reinstatement of the Glass-Steagall Act separating commercial from investment banking.

That would "make banking boring again," some pundits have complained, but taxpayers wouldn’t be on the hook if the speculative investments had turned sour since the gambles wouldn’t have been made with government insured deposits.

Here, many experts believe that Europe continues to play with fire by declining to separate derivatives trading from depositor banking. Instead, European regulators so far have opted only for more transparency by moving derivatives trading out of the shadows to public stock exchanges, where they will be traded and processed by clearing houses that have to comply with stricter governance rules. Trade repositories with databases will be set up to collect data on the status of derivatives contracts to give regulators a better insight into potentially risky deals. This is one area in which the U.S. has led Europe, with Dodd-Frank prohibiting any U.S. bank from investing 97% of its core capital in risky investments like hedge funds, as well as requiring more transparency.

6. ‘Too big to fail.’ Both Europe and the U.S. have been criticized for their reluctance to break up any bank deemed to be so big as to represent a potential threat to the financial system. But European regulators have devised another way to approach this. Recently the European Commission, the executive arm of the EU, has proposed giving regulators the power to block new products (like derivatives) and limit trading risks at banks and financial institutions that would need "extraordinary public support" during a crisis because they are so large. The European-led Financial Stability Board, a global group of regulators and finance ministry officials, is in the process of identifying financial institutions "of such size, market importance, and global interconnectedness that their distress or failure would cause significant dislocation in the global financial system." Such banks would be subject to tougher regulation and oversight.

7. Credit rating agencies. The Big Three rating agencies, Moody’s, Fitch’s and Standard & Poor’s, have engaged in corrupt practices, like selling AAA ratings for investments they knew had been designed to fail. They continue to add to the sovereign debt crisis in Europe by degrading bond ratings of certain countries based not on economic fundamentals but on speculative hype.

So Europe wants to change the equation here, moving supervision of rating agencies to one of its new regulatory bodies with significant powers of inspection, greater disclosure of information on the investments provided by the companies, breaking up a cozy, insider game and allowing for unsolicited ratings by other, more industry-independent agencies. The United States also has passed some reforms, including more oversight by the SEC, more transparency of ratings methodologies and new rules to prohibit conflicts of interest and liability for the rating agencies. But the U.S. approach has been to encourage a reduction in overall reliance on ratings, while the EU wants greater competition for the Big Three rating agencies.

8. Overall regulatory supervision. The four newly launched EU agencies have been praised by experts because they will result in clear lines of responsibility and have the potential for greater EU coordination of supervision. But the U.S. has shifted the primary responsibility for financial regulation and oversight to an already overwhelmed Federal Reserve Board, and to the Office of the Comptroller of the Currency, that experts say "appears to compound problems created by a patchwork approach" and "create uncertainty about… ultimate responsibility for supervision."

Other proposed reforms include redesigning the terms of future bailouts so that private creditors, such as banks, hedge funds and bond holders, take the hit for at least part of the losses, instead of the taxpayers alone. Previous reforms include bestowing more oversight power to Eurostat, the EU’s statistics and data collection agency, to audit budgets of member states to provide more transparency and to ensure that no country can submit falsified finance reports (like Greece did with the help of Goldman Sachs). Europe also has launched a trillion dollar rescue package, a kind of European Monetary Fund that can help prevent the default of a member state and generally act as a financial backstop for euro zone countries.

For the first time in its history, eurozone members are loaning money to each other, a momentous development for countries that fought bloody wars against each other not that long ago. In return, procedures are being developed that will require member states to adhere to certain agreed limitations regarding fiscal expenditures and low budget deficits, a clear step towards a tighter fiscal union.

So despite the PIIGS crisis, 2010 was an important year of reform. Indeed, one of the silver linings of the crisis has been that it has provided a mighty stick for prodding member states further down the path of reform. This is resulting in nothing less than a redesign of the global financial system.

In comparing the EU and U.S. scorecards, Paul Horne, former managing director at Smith Barney/Citigroup, has said that "the EU’s new architecture must be rated as ‘very significant’," but that "the Dodd-Frank legislation is more a reshuffling of the regulatory patchwork and may not address the underlying structural problems," says Horne.

"The eurozone, and by extension the whole EU, has emerged strengthened by the showdown over Greece and other EU countries with unsustainable budgetary policies that were being pushed toward default by the bond vigilantes."

Contrary to what euro-skeptics like Paul Krugman, Wolfgang Munchau and others have written, Europe has not dithered or sat back helplessly. Quite the contrary, it has been a busy and productive year, albeit a difficult one. Using its trademark practice of multilateralism and consensus-building, Europe has painstakingly pieced together the direction and details for a new economic order.