International Banking: Regulation, A Capital Idea?

As soon as I saw the cover of last week's print edition of The Economist, I knew it was going to be an especially interesting read (moreso than usual). The special focus of the May 11th issue is on the current state of international banking--in particular the future of investment banking in the wake of the 2007-2008 collapse and the ongoing recovery.

While the "Leaders" piece on the resurgence of American investment banks vis-a-vis their European cousins/competitors is fascinating, as is this "Twilight of the Gods" piece on the leaner future of investment banking, it is the article on new banking regulations and their impact on the dynamics of international finance that has most intrigued me.

Entitled "Regulation: The bite is worse than the bark," the article starts by summarizing the atmosphere surrounding new and proposed banking regulations, using a quote from the current chairman of UBS, Axel Weber. In an interview, Mr. Weber stated, "The mood among investment banks that I talk to...is such that they expect that the regulation is over, they expect that they will be able to keep growing their balance-sheets, that they will be growing bigger than ever. The mood among the regulators I talk with is more like 'we haven’t even started.'"

While Swiss banks such as UBS and Credit Suisse have been hit particularly hard by newer, stricter regulations, Mr. Weber is uniquely qualified to comment upon the sentiment on both sides of the regulatory divide. And his comments are particularly troubling for international banks operating in America--not just the Swiss, but British and Germany firms as well.

But first, an overview of the three primary options available to regulators:
1) Higher capital and liquidity requirements;
2) Restrictions on bank activities such as trading for their own profit;
3) Structural changes such as forcing banks to “ring-fence” their retail banks from their trading businesses or to reorganise global businesses into national subsidiaries.

All banks are set to be subject to at least one of the three forms of corrective medicine, but the bigger and more complex banks likely face at least two if not all three forms of regulations in the near future.
I'll save the technicalities and complexities of Basel 3 and the Volcker Rule for a future blog post; but suffice it to say that while the new rules will likely create a more stable financial system, they are also having unintended consequences for international investment banks.

While none of the above regulations pose a deep, mortal threat to the future of America's biggest investment banking firms, The Economist reports that two further sets of rules being discussed "could dash the hopes of Europe’s remaining big investment-banking contenders, Barclays and Deutsche Bank, of being able to go on challenging the dominance of America’s biggest banks."

The first is "a proposal to separate investment banking from retail banking," which in Britain could mean the construction of a Chinese Wall of sorts between the retail-banking arm and the investment-banking division of a bank. Continental Europe, meanwhile, "is debating variations of a plan by Erkki Liikanen, the governor of Finland’s central bank, to separate banks’ trading operations." Both potential rules would mean an increase in funding and operation costs for Europe's banks, and would deter big global banks from operating in Britain or Europe.

America, meanwhile "has made it clear it wants to be in the game," and it has been American banks that have led the aggressive resurgence of Wall Street and fueled overall banking sector recovery. But in Washington, DC, a second set of regulations is on the drawing board that could deal a severe blow to the American operations of European-based global banks, by forcing big foreign firms to establish local holding companies for their American subsidiary operations. This would most obviously and immediately impact Deutsche Bank and Barclays, two of the leading European banks which have both avoided the new capital requirements by moving assets and deregistering their American holding companies.

As The Economist explains, the proposed regulations on foreign banks make perfect sense to American regulators: "if a big European bank collapses on their doorstep, they do not want to have to ask its home country for money." However, an executive at Morgan Stanley has estimated that Deutsche Bank has a hidden capital deficit of $20 billion in its American business that would be exposed by the new regulations. Barclays is in a similar situation.

Image taken from blog Special FX for Wizards

The bottom line? "If other regulators were to follow its [America's] lead and force all foreign banks to hold capital and liquidity locally, the era of financial globalisation would be over." And the end of global finance is something I don't think even the most gung-ho regulator truly wants. Personally, as someone interested in a career in international finance and who is considering working at a firm such as Barclays or DB after graduation, financial globalization is certainly something I hope continues for a long, long time.


You can read the article in full at this link: Regulation: The bite is worse than the bark. Feel free to leave your thoughts and comments below.

From Russia, With Default: Russian Debt Crises and Global Finance

I finished reading The Ascent of Money while sitting in New York City's Bryant Park last Saturday, with the mammoth Bank of America Merrill Lynch tower as a backdrop, the Lord of War soundtrack as background music, and the occasional stray ping pong ball to bring me back to my surroundings. After three long days of investment banking networking and meetings with various IU alumni in the city, it was nice to sit and take in the somewhat paradoxical combination of parks & rec and metropolitan mayhem that New York has to offer, all while reading about the history of finance.

One of the themes throughout Niall Ferguson's book is the inherently international nature of finance and banking, and how seemingly unconnected transactions and events can have disastrous ripple effects leading to global crisis. This is something that became all too obvious between 2007 and 2009, when the U.S. subprime mortgage and CDO meltdown led to not only an American but also a global recession from which international markets are still struggling to recover. Indeed, while the cover of the current issue of The Economist announces "Wall Street is Back," the British newspaper doubts that investment banks will ever fully regain the levels of profit and success they attained prior to 2007.

Yet massive global crises caused by national-level defaults and instability, far from being a 21st century phenomenon, have been a variation on a theme for at least a century now. Two instances that I find particularly intriguing, given my interest in Russia and Eastern Europe, are the Russian defaults in 1918 and 1998. In both cases, national-level financial problems in Russia led to global financial pandemic.

The assassination of Archduke Franz Ferdinand, which led to the outbreak of hostilities in the Balkans and ultimately triggered World War I, did not cause any financial reaction until late July of 1914. Once investors and financiers realized the impending likelihood of global war, however, they were quick to react, and one of the first victims was the Russian economy. Although Russia had one of the largest standing armies in Europe at the time, its financial and political systems were not regarded as very stable, and a massive selloff of Russian securities ensued. This in turn led to a drastic drop in value for the ruble, followed by a similar slump in the dollar once American securities were unloaded by Europeans as well. 

Global meltdown quickly ensued, as British banks were flooded with sell orders. Soon most financial systems in Europe faced a mounting liquidity crisis, which the unfolding war did nothing to help. To staunch the financial bleeding, the world's major stock markets completely shut down for several months. It was an unprecedented event and one that has not been repeated since; but it succeeded in averting a full-blown global crash that likely would have been at last as bad as the one that kicked off the Great Depression in 1929.

Returning to Russia, however, the Tsar's government simply suspended the gold standard and any convertibility of rubles into gold, which led Russian bond prices to collapse, followed in short order by the Romanov dynasty itself. In 1918 the new Bolshevik regime defaulted on all of its bond debt, and by the 1920s Russian bonds were trading around 20% of face value. It was only through forced, Soviet economic management that the Russian financial system was brought back to a semblance of life and was able to grow during the subsequent depression era of the late 1920s and early 1930s.

Russian Freedom bond, 1917. Image courtesy of Wikipedia.

Russian default precipitated a similar global crisis in 1998, again due primarily to overarching economic and political reasons. Following the collapse of the Soviet Union and the "opening" and "freeing" of Russian markets to the rest of the world, Russia's supposed emerging economy entered a tumultuous period dominated by oligarchs and overly reliant on oil revenues. Overwhelmed with political turmoil and botched attempts at privatization, Russia defaulted on its foreign and even rouble-denominated domestic bond debt in August of 1998.

The shockwaves were immediate and devastating. While the limitations and weaknesses of the Russian economy were known at the time, the Russian default blew out bond spreads, caused equity volatility to spike, and crashed market indices. Perhaps the most damaging and most (in)famous results of the Russian default, however, was its central role in the collapse of hedge fund Long-Term Capital Management. Using complex and sterilized mathematical modeling, LTCM had bet big that the markets would never lose more than $45 million in a single day. The Russian default caused the markets to los $550 million on August 21, 1998 alone. The continued losses drove up LTCM's leverage and crashed its supposed infallible modeling, leading to the collapse of the hedge fund and a massive Wall Street bailout that would foreshadow the more recent bailouts following the 2008 financial crisis.

The 1918 and 1998 Russian defaults were separated by 90 years of supposed financial evolution and progress, yet history certainly seemed to repeat itself. In both instances, the supposed financial invincibility and hubris of investors (whether Western Europeans or LTCM) was reduced to panic due to events half a world away, in a country and financial system regarded even today as tangential. The lesson to be drawn--from these incidents and from Niall Ferguson's book in general--is that as integral as international finance has been to the interconnected ascent of man and money, the key to establishing a successful financial history of your own is knowing and understanding the history of finance. In the grand scheme of things, global dynamics and international events can often be far more important than technical valuations and mathematical models.