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Open markets (except for banks): why bank regulation risks upsetting economic recovery

Globalisation is a fact of modern commercial life. Cross-border investment and trade flows occur on a near-universal basis across the world, and deliver massive economic benefits – to investor and investee, importer and exporter alike – by enabling efficient markets. Trade liberalisation is a commonly understood engine of growth, and currently touted as a potential route out of the economic stagnation that has followed the financial crisis: witness the current talks over an EU-U.S. trade pact.

Banks – and in particular global banks – are the handmaiden of cross-border commerce. Take a U.S. manufacturer which exports goods to the EU. Its customer is likely to need access to trade finance, and it will likely want to hedge the foreign-exchange risks associated with receiving Euro income but having a U.S. dollar cost base. The U.S. exporter will have a relationship with a bank. The bank will run a current account for, and provide finance and foreign exchange hedging to, the exporter. In order to hedge the currency (and perhaps credit or interest rate) risk that it has assumed, the bank will deal in the wholesale market for risk. That market is global, but physically located in the major financial centres – including London. In colloquial terms, the bank will bring its risk to market, much as a farmer might have once brought his cows to market, in the City.

Bank regulation seeks to manage the risks associated with the activities of the bank – recognising that financial intermediation, and taking of deposits, are systemically important and that bank failures impose substantial economic and societal costs. Its primary tools are prudential – requiring that banks be fit, proper and have adequate capital and liquidity to support the risks that they intermediate.

Bank regulation is a dark, abstruse and pessimistic art. It is also inherently nationalistic: regulatory authorities are typically required to look only to national interests, consistent with the boundaries of their political masters. Its practitioners, being obliged to worship at the altar of national financial stability, feel unease at "their" banks participating in a global market. This is because it lies outside physical boundaries, complicates supervision, and poses risks if one of their banks fails in a disorderly way. Regulators are also inherently xenophobic. They worry that foreign banks may operate to lower standards, and thus have an unfair competitive advantage over local banks; that they might export funding out of the country and then fail; that their failure may lead to unfair treatment of local depositors; and that their failure might have local systemic repercussions. Most of all, they worry that they do not have control over foreign banks, or foreign activities of local banks. These are all legitimate concerns.

For the regulator (and increasingly for politicians), the natural response is to put up barriers to limit these risks. These may include barriers to branches of foreign banks conducting business locally – the recent U.S. Federal Reserve System proposals on foreign banking organisations, and debate on requiring "subsidiarisation" (incorporation) of U.S. branches of foreign banks, are examples. They may include barriers to undertaking foreign business – the forthcoming implementation of the Independent Commission on Banking in the UK will restrict UK retail banks within the "ring-fence" from participating in international financial markets, and parallel proposals are in play in Europe following the Liikanen review. Even today within Europe, where banks benefit from Treaty rights to "passport" cross-border, there is increasing evidence of regulators prohibiting branching by foreign banks. This tendency will only be reinforced by the events in Cyprus, in which UK and Greek branch depositors were only saved from substantial losses by political manoeuvring.

The effect of subsidiarisation or ring-fencing is to restrict national banks' access to the global marketplace for risk. This has an immediate effect, and a number of potential knock-on consequences. The immediate effect is the creation of a new tariff on risk management. The obvious example of this is additional capital and liquidity costs. Requiring a local subsidiary results in a duplication of the capital and liquidity costs associated with accessing the global market. The duplication of capital and liquidity requirements represents a cost to the banking relationship which will be passed on to the exporter. There are other costs too.

The knock-on effects are harder to predict, but extend far beyond the confines of the banking sector. One possible outcome is the fragmentation of the wholesale market. Where the tariff is too high, banks may simply cease to interact on a global basis – managing risk locally rather than globally. (Ironically this could put national banking systems at more, rather than less, risk.) Another, far more serious, consequence is the increase of funding costs and ultimately reduction of available funding to support real economic activity.

All of this may be entirely reasonable from the limited world view of the regulator. The regulator is not accountable for the economic consequences of regulatory barriers to growth. But by reversing globalisation in the financial sector, politicians risk impairing the very economic recovery they seek to promote.

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