Potential Consequences of the EU's Proposed Regulatory Changes

The European Union is considering a dramatic revision of the current institutional arrangement concerning banking regulation and supervision. Currently, members of the EU must implement international capital standards -- the Basel accords -- but regulation of domestic financial sectors is left up to national governments. Some governments choose to have their central banks regulate, others give that authority to a separate agency; each is fine under current EU rules.

That may change. Given the instability in the EU banking markets, and the fact that EU members must allow free movement of capital within the EU, the institution is considering moving supervisory authority to the transnational level:

The leaders of France, Germany, Italy, Spain and Austria are willing to back a powerful supranational supervisor, and a decision to relinquish national control over cross-border banks is being prepared for next week’s EU summit, according to senior officials. One said the new-found political impetus was “astonishing”.

The "astonishing" political impetus has come from the fact that the EU is currently experiencing a number of bank runs, capital flight from the periphery to the core, and a general lack of trust in the solvency of many of its financial institutions. To shore up confidence, many in the EU would like to create a "banking union" that would involve continent-wide deposit insurance for EU banks. In exchange for that guarantee, states would have to give up sovereignty to a higher body, which would presumably be heavily influenced by the core European countries (in this case, Britain, Germany, and France).

What would the effect of this be? It turns out that I've done some research on that question.* That work suggests that the answer is: it depends. Specifically, it depends on who the regulator would be. The top two choices appear to be the European Central Bank and the European Banking Authority. Why does it matter?

My research, building off of some work by Copelovitch and Singer, argues that giving regulatory authority to central banks alters the policymaking incentives that central bankers face. Without getting too wonky, it incentives central banks to privilege the needs of the banking sector when choosing monetary policy, as financial instability could lead to the loss of their authority. This, in turn, incentivizes banks to behave more riskily, as they expect to receive preferential treatment from sympathetic central banks, so long as they stay above the statutory requirements. The cumulative result is a more bank-friendly monetary regime (the Copelovitch and Singer result) and a more risk-friendly banking sector (my result, supported by a ton of statistical tests). This may not be what the EU currently has in mind.

On the other hand, regulatory central banks may be better able to prevent financial instability in the first place by tailoring policy to the needs of the financial sector. I do not explicitly study this question, and I doubt it is strictly true, but central bankers have argued according to this logic in the past. Alternatively, unifying regulatory and monetary authority could reduce institutional competition and lead to better-coordinated policies. Of course, if that coordination is in a direction that rewards greater risk-taking by EU banks then that might not be the best thing.

*Currently under review so no link, but interested parties can e-mail me for a copy.

Basel Is Not "Anti-American"

I see (via Felix Salmon) that JP Morgan executive Jamie Dimon thinks the Basel bank regulations are "anti-American". I have no idea what he means by that, but my working understanding of the Basel regulations is that from a competitiveness standpoint they are generally beneficial to large American firms (like JP Morgan), and generally harmful to European and Asian firms. As Salmon puts it:

I have no idea what Dimon thinks is anti-American about the Basel standards, which are certainly in the interests of the United States. In fact, by all accounts it was the US which was pushing for stricter rules, and had to compromise with the laxer Europeans, whose banks are much less well capitalized right now. US banks, including JP Morgan with its “fortress balance sheet”, are very well placed to navigate through the Basel rules and come out strong and dominant on the other side.  

European banks, by contrast, will have to raise a lot of very expensive equity. And UK banks, if the Vickers proposals are adopted, will be much less formidable in the international arena than they are right now, with most of their assets ring-fenced and unavailable for merchant-banking misadventures.

There are two basic ways to think about regulations like the Basel accords. The first way is to think in terms of externalities and welfare: regulations restrict the ability of banks to act riskily, which prevents them from generating negative externalities that spill over into the rest of society during financial crises. Thus, new regulations represent a redistribution away from banks to society at large. I think this is the wrong view.

A better approach, in my opinion, is to think of regulation as altering the competitive landscape in ways that benefit some firms and hurt others, and benefit some in the broader society while hurting others. Large incumbent firms often support new regulations that function as a barrier to entry for potential competitors. Regulations can lock in the market dominance of existing firms. This is what Salmon is talking about when he writes that "US banks are well placed to navigate through the Basel rules and come out strong and dominant on the other side".

So why is Dimon opposed to them? It could be that he doesn't appreciate this dynamic, but that sort of ignorance would wreak havoc on the assumptions used to generate the rent-seeking model of regulation. So let's not go there.

My guess is that Dimon recognizes the advantages of Basel rents but think they are smaller than the benefits to his firm of having lower regulations. That is, since JP Morgan is already at a competitive advantage over many of its competitors, and with the European banking sector apparently on the verge of collapse, he may believe that he doesn't need to collect rents for his firm to be profitable. If that's the situation, then the regulations restrict Dimon's flexibility without providing any significant competitive benefit.

That doesn't mean Basel is "anti-American" of course. For one thing, the Basel system could lock in market dominance for large American firms long into the future. For another, US policy makers hope to create a more stable financial system through Basel, not just secure profits for American firms. Of course Dimon may have a shorter time horizon, in which case the long-run benefits of Basel would be enjoyed by someone other than him, while the costs of initiation and compliance are borne by him and his friends.

The State of Banking

The Banker has released its annual report of the world's top 1000 banks. Despite the fact that profits collapsed over 85% from 2007 to 2008, the ranks are mostly unchanged from previous years. The Tier 1 capital rankings have also changed little as banks have raised massive amounts of public and private capital to off-set capital losses from the crisis, and aggregate Tier 1 holdings by the top 1000 actually increased in 2008. Perhaps more surprisingly, when government injections of capital are subtracted the rank order still changes very little, indicating that many of the top banks were not actually insolvent in the worst days of the credit crisis, but rather illiquid (this was Robert Rubin's argument back in September). Government-provided liquidity gave banks a window to raise more capital, unwind some of their positions, and make it through the crisis relatively unscathed. Now that the worst is (hopefully) past, banks are paying back the TARP money as fast as the government allows them.

This massive worldwide effort to raise capital has been largely successful: in aggregate, new capital has almost exactly off-set writedowns and losses for the year. In Europe and Asia, new capital is actually greater than the total losses. This is not to say that there haven't been significant losses; there have been, and they've been disproportionately concentrated in the U.S. and U.K. But the public and private efforts to recapitalize the international banking system appear to have been largely successful.

Interesting Links.

A Special Report on International Banking from the Economist

The Last Temptation of Risk by Barry Eichengreen

Cuban Charter Companies

Mexican Migration to US in Decline