Markets Insight
April 23, 2013 6:11 pm
Markets Insight: Global banking and regulation already fractured
System diversity is reduced by pushing banks in a monoline direction
Is it more than sabre-rattling? The response by Michel Barnier, the EU commissioner in charge of financial services, to US plans to force foreign banks to hold more capital in their US subsidiaries certainly sounded bellicose. The Frenchman even threatened Ben Bernanke, chairman of the Federal Reserve, with “a protectionist reaction”.
This is an odd way to manage relations with the central bank that provided emergency liquidity to European banks in New York after the collapse of Lehman Brothers in 2008 and subsequently eased the European banks’ dollar funding problems. The Fed is also just one of many regulators seeking to trap foreign capital and liquidity in their own jurisdiction.
Fragmentation in global banking is already an established fact. A shortage of dollar funding has already brought about a dramatic decline in European banks’ share of Asian trade finance, which is substantially dollar based. They have also been obliged to retreat from US businesses because the US banks have a funding advantage on their domestic territory.
With capital under pressure and markets becoming tougher, many banks across the world have been forced to go back home, where returns are superior thanks to the benefits of scale and stronger distribution, and funding is easier.
In the eurozone, fragmentation is apparent in the huge difference in borrowing costs for comparable companies in Germany and France as compared with Spain and Italy. Banks have also deliberately set out to protect themselves from redenomination risk if a member falls out of the monetary union by matching assets and liabilities on a country basis.
That risk is perceived to have diminished since the Cyprus bailout. Yet despite growing optimism, witnessed by the fall in Italian government bond yields this week to levels not seen since before the eruption of the sovereign debt crisis, the eurozone remains the biggest threat to global financial stability. This is not least because of the toxic and incestuous embrace between the banks and sovereign debtors. The desire to match subsidiaries’ balance sheets on a country basis has not diminished.
Looked at from Mr Bernanke’s point of view European banks are still over-dependent on wholesale funding. EU policymakers have been slower than their US counterparts to force banks to strengthen their balance sheets.
The US move is widely reckoned to be directed specifically at Deutsche Bank, and it is not difficult to see why. Its report and accounts for 2012, published last week, show a leverage ratio of only 2.7 per cent. In other words, it would take a fall of only 2.7 per cent in the value of the assets to wipe out the bank. That is unnerving given the widespread scepticism about the valuation of bank assets and the significant discount to net asset value at which Deutsche’s shares trade.
Against that background the Fed could be excused for asking what would happen if Deutsche’s US subsidiary, which is reported to have negative equity, were to run into any kind of trouble. Parental backing in this case does not look as substantial as it should.
Of course, everyone assumes that the German government would regard Deutsche Bank as too big to fail. But if this became an issue in the midst of a rip-roaring eurozone crisis, the government’s ability to move might be more heavily constrained than it appears today, as might the ability of the parent. It is, after all, the job of central bankers to consider such extreme scenarios and to balance the need for financial stability and the protection of domestic taxpayers against the promotion of economic growth.
The European banks are in a tough place. They have not been helped by the instinctive desire of EU policymakers and regulators such as Mr Barnier for forbearance, nor by a stagnant eurozone economy for which the latest data hold out little hope of an immediate upturn. The wholesale and investment banking arms of the European banks are having great difficulty covering their cost of capital. By contrast their US competitors have the benefit of a stronger economy, stronger balance sheets and more buoyant profits.
Should we worry about the accelerating retreat from the globalisation of finance and capital flows? It is surely right that taxpayers are being protected from weak bank balance sheets and excessive risk-taking. Yet there are disadvantages. A nationally segmented system reduces financial capacity. That is a concern in emerging markets as well as in the developed world.
Perhaps more worrying about this trend towards regulatory financial protectionism is that it reduces the diversity of the system by pushing banks in a monoline direction. They thus become more vulnerable to shocks, with potentially nasty systemic implications. The trade-offs here between the different interests tend inevitably to be rough and ready.
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This is an odd way to manage relations with the central bank that provided emergency liquidity to European banks in New York after the collapse of Lehman Brothers in 2008 and subsequently eased the European banks’ dollar funding problems. The Fed is also just one of many regulators seeking to trap foreign capital and liquidity in their own jurisdiction.
Fragmentation in global banking is already an established fact. A shortage of dollar funding has already brought about a dramatic decline in European banks’ share of Asian trade finance, which is substantially dollar based. They have also been obliged to retreat from US businesses because the US banks have a funding advantage on their domestic territory.
With capital under pressure and markets becoming tougher, many banks across the world have been forced to go back home, where returns are superior thanks to the benefits of scale and stronger distribution, and funding is easier.
In the eurozone, fragmentation is apparent in the huge difference in borrowing costs for comparable companies in Germany and France as compared with Spain and Italy. Banks have also deliberately set out to protect themselves from redenomination risk if a member falls out of the monetary union by matching assets and liabilities on a country basis.
That risk is perceived to have diminished since the Cyprus bailout. Yet despite growing optimism, witnessed by the fall in Italian government bond yields this week to levels not seen since before the eruption of the sovereign debt crisis, the eurozone remains the biggest threat to global financial stability. This is not least because of the toxic and incestuous embrace between the banks and sovereign debtors. The desire to match subsidiaries’ balance sheets on a country basis has not diminished.
Looked at from Mr Bernanke’s point of view European banks are still over-dependent on wholesale funding. EU policymakers have been slower than their US counterparts to force banks to strengthen their balance sheets.
The US move is widely reckoned to be directed specifically at Deutsche Bank, and it is not difficult to see why. Its report and accounts for 2012, published last week, show a leverage ratio of only 2.7 per cent. In other words, it would take a fall of only 2.7 per cent in the value of the assets to wipe out the bank. That is unnerving given the widespread scepticism about the valuation of bank assets and the significant discount to net asset value at which Deutsche’s shares trade.
Against that background the Fed could be excused for asking what would happen if Deutsche’s US subsidiary, which is reported to have negative equity, were to run into any kind of trouble. Parental backing in this case does not look as substantial as it should.
Of course, everyone assumes that the German government would regard Deutsche Bank as too big to fail. But if this became an issue in the midst of a rip-roaring eurozone crisis, the government’s ability to move might be more heavily constrained than it appears today, as might the ability of the parent. It is, after all, the job of central bankers to consider such extreme scenarios and to balance the need for financial stability and the protection of domestic taxpayers against the promotion of economic growth.
The European banks are in a tough place. They have not been helped by the instinctive desire of EU policymakers and regulators such as Mr Barnier for forbearance, nor by a stagnant eurozone economy for which the latest data hold out little hope of an immediate upturn. The wholesale and investment banking arms of the European banks are having great difficulty covering their cost of capital. By contrast their US competitors have the benefit of a stronger economy, stronger balance sheets and more buoyant profits.
Should we worry about the accelerating retreat from the globalisation of finance and capital flows? It is surely right that taxpayers are being protected from weak bank balance sheets and excessive risk-taking. Yet there are disadvantages. A nationally segmented system reduces financial capacity. That is a concern in emerging markets as well as in the developed world.
Perhaps more worrying about this trend towards regulatory financial protectionism is that it reduces the diversity of the system by pushing banks in a monoline direction. They thus become more vulnerable to shocks, with potentially nasty systemic implications. The trade-offs here between the different interests tend inevitably to be rough and ready.
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Copyright The Financial Times Limited 2013.
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