State Banking, Globally

A standard refrain from U.S. banking industry lobbyists is “you cannot put us at a disadvantage relative to our overseas competitors.”  The Obama administration has largely bought into this line and cites it in public and private as one reason for opposing size caps on our largest banks and preventing Congress from raising capital requirements.

The US Treasury puts its faith instead in the Basel Committee on Banking Supervision process, a somewhat murky convocation of bank regulators from various countries that has a weak track record in terms of setting sufficient prudential standards (also the assessment of Dan Tarullo, now an influential Federal Reserve governor; disclosure, I have a part-time position at the Peterson Institute, which published his book).  But, the official US reasoning goes, the crisis of 2007-08 was so traumatic, our European counterparts will now want to be more careful.

The problem with this approach is that there is a fundamental and widening gap between how banks are seen in the United States compared with other leading countries.  To some extent this is about tradition – from the early 19th century the US has a long history of suspicion regarding the political and economic power of banks, whereas Germany has tended to have a more cooperative relationship between the state and big banks.  It is also about what we think government should do – our “pro-banking” group in government draws a lot of support when it insists that the federal authorities should not run banks, but in France there is much less reluctance to mix politics and financial business.

All of this matters because if a government stands behinds its banks, those banks need much less capital in order to be viable.  Capital is a buffer against losses – it represents the shareholders’ wealth and as such “absorbs” the damage caused by bad loans or disastrous purchases of securities.  If a bank’s capital falls to zero (or below), it is out of business – unless it can raise new capital, which would typically be hard to do from private markets for a failed bank.

But if the state stands behinds its banks, it will be more willing to “inject” capital as needed.  Government officials may not want to do this as a matter of routine – primarily because that would worsen the moral hazard problems of the banks’ management, i.e., they would have no incentive to be careful.  It could also be politically unpopular to provide too much support in this fashion.

Still, there is no question that while we wait for the public results of the European bank stress tests, the relevant governments are making it quite plain that their big banks will not be allowed to fail.  We shall see if this commitment comes with more effective corporate governance and personnel changes than was the case in the United States – when the top 13 Bankers (and almost everyone else in leading financial institutions) were bailed out unconditionally.

In any case, the global competitive landscape is changing unambiguously.  Despite all the obvious incentive problems in the eurozone writ large (including irresponsible lending at many levels), the state is not retreating from banking in Europe – on the contrary, it is becoming more deeply committed.  Under these circumstances, the Basel process is even less likely to lead to a meaningful increase in capital requirements.  Even if the headline numbers look reasonable, there will be so many exemptions and exceptions – at European insistence – that the ultimate outcome will not put stronger buffers against loss into big global banks.

And onto the global scene now burst the Chinese banks, loved by the markets and backed by the state  (as seen in this week’s IPO by the Agricultural Bank of China).  To be sure, there is a governance structure around these banks that has worked after a fashion within China.  But whenever banks go global, they tend to slip outside the domestic constraints that have worked well – remember what happened when Japanese banks went on a global buying spree in the 1980s; this is also a potential issue as Canadian banks expand internationally.

What does this mean for US-based global banks in the aftermath of the Dodd-Frank financial reform bill?  Their leading foreign competitors are backed by creditworthy governments, e.g., Germany (and arguably some other eurozone countries) and China.  Without question, this provides a form of nontransparent, unfair, and dangerous subsidy to those financial sectors.  How do we compete on this basis?

To some degree, of course, we have followed suit – although our government guarantees for Too Big To Fail banks are arguably more hidden and more dangerous than what we see in Europe.

But is this really where we want to be?  When hidden subsidies are provided to various nonfinancial sectors in our trading partners, we take that up with the World Trade Organization.  Banking has not, until now, been seen in the same terms – the idea was that we could get sufficient convergence through other means, including the Basel Committee. 

With the European and Chinese states on course to back their global banks for the indefinite future, this traditional approach increasingly seems unappealing.  Either we will play in the same state-backed banking space (and face the dangerous consequences) or we will need to think about the international basis for trade in financial services from a new perspective.

An edited version of this post appeared this morning on the NYT’s Economix.

Originally published at The Baseline Scenario and reproduced here with the author’s permission.