As promised last week, FedFin yesterday released our issue brief on pending threats to trade in financial services. More on it may be found in the American Banker. In our paper, we forecast retaliation by the European Union if the U.S. pursues the protectionist course threatened late last year by FRB Gov. Tarullo and reinforced in the past few weeks by statements from senior GOP legislators and by the Trump Administration. Today, a top EU financial policy-maker fulfilled our unhappy forecast, saying clearly that if Mr. Trump does his “big number” on Dodd-Frank, then Europe will retaliate by insulating itself from what it believes would be a far riskier U.S. financial system. Other alliances – those in Asia with China as a case in point – will also gain new ground, sowing the seeds not only for a far more dangerous global financial system, but also a profound challenge to the franchise value of cross-border financial companies.
As matters stand now, the global financial framework is in danger of returning to the financial centers not of excellence, but rather of regulatory arbitrage that ruled global finance until Basel I began harmonizing critical standards in 1987. The world then truly was one of lowest-common-denominator prudential regulation – at least where there was any – with global banks dominating the financial field not because they were better or safer than non-banks, but instead because they had de jure or de facto taxpayer backstops and thus could not fail no matter what risks they ran.
One might argue – indeed Basel critics on the Hill have – that the global capital rules did little to stabilize finance in the decades since and even played a role in firing up the 2008 financial crisis. But, careful analysis shows the fallacy of this critique of an admittedly-imperfect global capital regime.
First, we don’t know the counter-factual – that is, what might have happened during several close shaves in the 1990s without higher capital on a cross border basis. Second, the crises of the 1980s, 1990s, and 2000s had their roots at least as much in financial companies outside the reach of Basel rules as they did in the big banks through which these non-banks shocks then were transmitted into the global financial lifeblood. Finally, we simply can’t know if banks would have known better about taking on all this risk from non-banks if they and their counterparties hadn’t counted on TBTF.
Banks are not the only cross-border companies whose fate lies in the outcome of this looming trade war. Insurance and asset management companies are perhaps at even greater risk because of their larger exposure to the edicts of host-country and any retaliation under them.
Insurance is the only U.S. financial sector in which the U.S. runs a trade deficit, making it a tempting target for trade sanctions for nations looking for ways to retaliate. If for example the new Congress and Trump Administration renege on the hard-fought covered agreement following tough hearings next week, we think sparks will fly and then catch fire in terms of EU demands for full Solvency II compliance and other formidable barriers to U.S. insurance operations. After all, why not protect the only insurance sector with an edge over the U.S. now while the broader battle begins over trying to recapture lost global share in banking, asset management, and the full range of capital-markets activities key to economic prosperity?
So far, we’ve only seen warning shots from each side of the trade-in-financial-services battle lines. What scares me most is that these shots could well land in a minefield, blowing up a lot more a lot faster than many may now anticipate. Think about it – nations will withdraw behind their own prudential barricades, some reducing safety-and-soundness standards within them to provide regulatory relief, a competitive edge, or just because the old rules came from the last party in power. Any increase in risk will come in concert with stiff new barriers to taxpayer bail-out, further destabilizing cross-border finance under stress sure to come with lax prudential standards.
Making it clear that any faltering financial company is on its own – warranted though this is for market discipline – could well spark the types of panics we saw at the outset of the 2008 crisis – as I said, much of it started in non-banks without a TBTF backstop. Banks regulated like non-banks and removed from the taxpayer tap will certainly be less regulated and more profitable, but also a lot more dangerous absent very careful calibration of this new financial framework.
Our issue brief lays out only the threat to global finance now made even clearer by events of the last few days. Next up has to be a defense of this framework based not only on facts such as those I’ve outlined above, but also by clear articulation of the stakes in this battle for innocent bystanders.