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The Battle for Global Banking Regulations

Thomas Hoenig

(The European Business Daily) – Thomas Hoenig has seen his fair share of banking crises in the United States over the last few decades. He saw the recession in the 1980s, when hundreds of savings and loan banks had to pack up. Then came the 2008 financial crisis. After working for the Federal Reserve for many years, the 70-year-old is now vice chairman of the Federal Deposit Insurance Corporation (FDIC). He made a name for himself as a major critic of big banks, and the Wall Street Journal has speculated that President Donald Trump may appoint him to the position of vice chairman of the Federal Reserve. He is not the kind of person any bank wants to have as an adversary. For German banks, Mr. Hoenig is already proving a powerful adversary in a dispute financial insiders have referred to as an “economic war” that – if it remains unsolved – could mark the end of uniform global banking regulations.

The central issue involves how banks are permitted to calculate their credit risks. This determines how much capital banks are required to hold in reserve to ensure that these risks do not lead to losses. The higher the requirement, the better banks are prepared for new crises. But if it is too high, it becomes difficult for many banks to satisfy the requirement. European banks in particular have had trouble quickly increasing their capital, whereas American banks are already in better shape today.

Of course, this is really about how easily banks can fudge their figures, one experienced banker admits –

“What else?”

The U.S. and the European Union have been negotiating for years, but now that they have reached the home stretch, talks have suddenly ground to a halt.

In the U.S. corner, we find Mr. Hoenig: “I don’t want anyone to leave the talks but I strongly believe that we need financially sound banks. I don’t want to give up this goal under any circumstances.”

On the other side of the conflict is Andreas Dombret, the top banking regulator on the executive board of Germany’s Bundesbank. The 57-yearold sees himself as Europe’s chief negotiator and has the backing of France and the European Commission.

“There is a real possibility that everything will fall apart.”

Europeans fear that the Americans’ demands will lead to capital requirements for European banks that are much too high. This could force institutes to drastically curtail lending, adversely affecting already-weak economic growth in the E.U. At the same the time, the plans could strengthen U.S. competitors. In November, Mr. Dombret threatened that there would be “no agreement at any cost.”

The conflict is being waged in one of the most powerful bodies of the global economy, the Basel Committee on Banking Supervision (BCBS), a group of banking supervisory authorities from 27 countries that is charged with establishing global rules for banks. Although their decisions are non-binding, they usually become law around the world. Germany is represented by the Bundesbank and its financial supervision arm, while the United States is represented by the Fed and the FDIC. Europeans and Americans interact with one another in the committee.

The extent of the crisis between the two sides became clear in early January, when an important meeting was cancelled. Over the new year period, it became clear that the differences were too great, according to a source close to the talks, adding that the prospects of an agreement being reached are now 50-50. There is real possibility that everything will fall apart. It would be a “disaster,” for the BSCS to become nothing more than a debate club, the source said.

For decades, the Committee has set the rules on howmuch equity capital banks must hold in reserve. As recently as the 1990s, the rules drew little distinction between the actual risks a bank was taking. A bank that was lending €1,000 to a dubious businessman had to keep asmuch of its own money in reserve for the loan as it did for a safe federal government bond. The loan’s default risk was irrelevant. As a result, banks preferred to lend their money to risky borrowers at high rates than be content with lower returns from safe borrowers.

The dangers of that approach were soon recognized, and the rules were reformed to allow banks to calculate their risks using their own models, and to balance their capital requirements accordingly – under the supervision of government regulators. Europe’s major banks, in particular, use this option today.

Deutsche Bank, for example, uses more internal models than any other bank in Germany. Its business, which encompasses €1.689 trillion, shrinks to €385 billion, about three quarters less, after being adjusted for risk. When Deutsche Bank says that it is holding 12.6 percent of capital in reserve for a rainy day, it means 12.6 percent of €385 billion.

There are consequences to this practice. In the financial crisis, many banks had too little capital to offset losses, and in many cases taxpayers had to bail them out. “History has shown that banks have scaled back their numbers,” said Mr. Hoenig. “Banks’ internal models should be used as tools only very rarely. They were not reliable.”

His adversary, Mr. Dombret, disagrees. The principle of determining risks on an individual basis must be preserved, so that “capital requirements reflect a bank’s actual risks as clearly as possible,” he said in November. The U.S approach ignores the fact that the European economy receives far more funding through bank loans than the U.S. economy, and that European banks keep their real-estate loans on their books instead of unloading them onto government mortgage providers, as the Americans do. Regional characteristic should be “adequately taken into account,” he added.

Mr. Dombret is being undermined by researchers. Studies conducted by the Basel Committee, for example, show that banks assess the risk of identical loan portfolios very differently, a conclusion that prompted Mr. Hoenig to call for “more standard models, so that the differences are smaller and we can feel more confident in the numbers that are reported.”

An analysis by Rainer Haselmann, a professor specializing in financing at the University of Frankfurt, also suggests that banks are exploiting the rules currently in place. According to his analysis, failure rates were higher when German banks used internal models instead of standard models to evaluate deals. Banks are seemingly aware of the higher risk, because they also charge higher interest rates for these deals. At the same time, however, they estimate lower capital requirements for the higher-risk deals.

A chat with one experienced Frankfurt banker, who declined to be named, reveals this is indeed the reality. Yes, banks do employ “armies of people” to keep pushing their capital requirements “lower and lower.”

This “massaging of figures” has gotten so out of hand, he explained, that regulators’ options have become limited.

The sticking point in the trans-Atlantic dispute is where to set the lower limit for banks. The Basel Committee has proposed that the capital requirement calculated by banks should stem at least 75 percent from on what standard models show. The United States is calling for 80 percent. Germany wants to accept no more than 70 percent.

The management consulting arm of the accounting firm PwC has calculated that European banks would need to procure €300 billion in new capital if the Basel plan becomes reality. German banks alone would each need an additional €30 billion. For some perspective, Germany’s biggest bank Deutsche Bank is currently worth €26 billion in market value.

If Mr. Hoenig were making the decision, the solution would be even more radical. In the future, banks would act in accordance with how much capital they have relative to the sum of all their transactions, without any risk-based adjustments, as they did in the past.

“European banks would need to procure €300 billion in new capital if the Basel plan becomes reality. German banks alone would each need an additional €30 billion.”

This is a “much more reliable, comparable measure,” said the U.S. regulator. He explained it is important for no one to have a particular advantage, and banks would be left to decide on their own transactions. “This creates the fair conditions that Europe wants,” he said.

This quota, known as the leverage ratio, already exists today, but only as a supplement to risk weighting. And Basel is only demanding 3 percent, while Mr. Hoenig wants more. “A minimum of 10 percent is a good starting point,” he said, suggesting that banks be given “a decade” to build up to 10 percent. In this period, banks would be allowed to pay dividends, but only to the extent allowed by their steady progress in increasing the new capital cushion. “This would generally strengthen confidence in the banks and the financial system,” said Mr. Hoenig.

That is unlikely to happen. Even a lower limit now being discussed, which constitutes a middle ground of sorts, will mean that Germany’s banks need more capital. From the standpoint of the Association of German Banks, the increase in capital requirements should remain “in the single-digit percentage range.” This should be feasible for all of Germany’s 1,600-some banks. But according to well-informed sources, 18 to 20 banks will likely need 15 to 20 percent more capital on average, even if Germany achieves all of its demands.

Once the dispute is settled, a long period for figuring out the implementation would be well in order. The Basel Committee meets next in early March. Its decisions must always be unanimous.

“I hope that we will reach an agreement,” said Mr. Hoenig, “because everyone wants a more stable banking system.”

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