The Economy

The Great Unraveling

Bank supervisors are quietly forcing a deglobalization of finance.
Economist StaffApril 23, 2013

Some on Wall Street casually call it the “anti-Deutsche Bank rule” because of its potential impact on Germany’s biggest bank. In truth, it should probably be known as the “anti-globalization rule” for the chilling effect it may have on cross-border banking almost everywhere.

At the end of this month the Federal Reserve will close its consultation period on proposals to reshape the regulation of foreign banks’ operations in America. The main proposals will overturn rules from the early 2000s that, in effect, allowed subsidiaries of well-capitalized foreign banks to operate in America without having to meet minimum capital requirements. Under the new proposals, foreign banks will have to ring-fence their American operations into separately capitalized and regulated subsidiaries; they may also have to be separately funded.

The finer details — such as whether parent companies can use debt to inject capital and funding into their subsidiaries — are still being haggled over. But if imposed in their strictest form the new rules may have big consequences.

Huw van Steenis, an analyst at Morgan Stanley, reckons that Deutsche Bank has a capital shortfall of as much as $20 billion in its American operation (see chart). That may be reduced to $7 billion to $9 billion if it cuts the size of its American balance-sheet by about a third. Even so, the cost of additional capital and the loss of earnings from shrinking its American business may be significant. Barclays, too, may have to inject capital into its American business, which holds about a fifth of its total assets.

To some extent, these two banks are facing the consequences of their own actions. Over the past two years Deutsche and Barclays have deregistered their American bank-holding companies to avoid some provisions of the Dodd-Frank act that would have forced them to inject more capital into the businesses. “Barclays and Deutsche brought it on themselves,” says a senior executive at a large American rival.

The Fed’s proposal nonetheless marks a sharp reversal of American policy. Even after the collapse of Lehman Brothers in 2008, American regulators were staunch defenders of global capital markets, arguing for international agreements to improve financial stability and against policies to encourage banks to subsidiarize their operations. Now American regulators seem more concerned about their ability to get access to capital held abroad in the event that a big foreign bank on their soil were to fail.

Daniel Tarullo, a governor of the Federal Reserve and the man most associated with the proposals, summed up the problem in a recent speech. “We have a significantly internationalized financial system, in which shocks are quickly transmitted across borders,” he said, “but a nationally based structure of regulation.”

Other countries are taking similar steps to carve big banks into separate operational fiefs. Britain is applying strict liquidity rules to foreign banks; local lenders will soon have to ring-fence their retail arms. A variety of European rules are under consideration that would compel banks to wall off their investment-banking and trading businesses. Across Asia subsidiarization rules are also being dusted off.

Forcing banks to subsidiarize makes lots of sense for regulators, particularly in the case of retail banks that are essentially local anyway. For big capital-markets businesses, however, it may lead to higher funding costs, trapped pools of capital and a loss of diversification benefits if banks cannot shift capital from healthy businesses to troubled ones.

A recent report by Oliver Wyman, a consultancy, and Morgan Stanley reckons that these rules could trim returns on equity for international banks by 2 percent to 3 percent. That might in turn lead banks to cut back cross-border activities, reducing the ability of the banking system to shift money from countries with a glut of savings to those that need it. “The model of global intermediation is quietly being deconstructed,” says Ted Moynihan of Oliver Wyman.

Indeed, there is evidence that cross-border capital flows are already in retreat. A recent study by McKinsey, a consultancy, found that since the crisis commercial banks have sold $722 billion in assets and operations, of which almost half were foreign. Within the euro area, banks have cut cross-border exposures by $3.7 trillion since the end of 2007 (the euro crisis explains some of that retrenchment, of course). Such reversals stand in sharp contrast to the years before the crisis.

Regulators understandably want to keep their own banking systems safe. But that should not mean discarding the benefits of financial globalization. The best outcome would be if regulators could agree on coordinated ways of cleaning up after the failure of big banks without having to splinter them like jigsaw puzzles.

© The Economist Newspaper Limited, London (April 20, 2013)

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