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City Journal Autumn 2009.
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After The Fall: Saving Capitalism From Wall Street--and Washington

After The Fall: Saving Capitalism From Wall Street—and Washington

by Nicole Gelinas

Global Finance’s State of Nature
Ambitions for a new world order are no match for national interest.
France plans to lure high-end finance jobs to its business district, La Defense.
Robin MacDougall/Getty Images
France plans to lure high-end finance jobs to its business district, La Defense.

Sarkozy put pressure on us,” reports a nonplussed banker to a colleague in a recent French-newspaper cartoon, referring to the French president’s campaign against financial-industry bonuses. “And then what?” his colleague asks. “And then nothing,” is the reply.

After a year’s worth of summits, lectures from the French and the Germans, vigorous intellectual debate from the British, and thousands of pages of commission reports, the French cartoon may sum it up best. The way national governments regulate their financial sectors hasn’t changed significantly anywhere, nor is it likely to. The reason: while everybody sees the problem with an unsustainable government-subsidized financial industry, coddled by a policy that protects firms that have become too big or complex to fail, no elected officials want their unsustainable, government-subsidized financial industry going somewhere else.

National leaders are, in effect, competing over which country can offer its financial sector the most generous economic subsidy. This losing game ultimately hurts the financial sector—which needs market discipline to reward success and punish failure—and economic competitiveness as well.

The financial crisis that started with American subprime mortgages spread to the global financial system in the spring and summer of 2007, when British, French, and German banks that had bought mortgage-related securities showed signs of distress. By late autumn 2008, after the U.S.-based Lehman Brothers investment bank’s disordered September 15 collapse, the crisis had led Western Europe’s major nations to stand explicitly behind their banks, offering them government money and various guarantees, just as America had done. On the Europe-wide level, the European Central Bank, which governs monetary policy in the 27 nations that use the euro, and the Bank of England rivaled America’s Federal Reserve in the extraordinary measures they took to keep money and credit flowing.

The French and the Germans determined that the crisis had sprung from the recklessness of “Anglo-Saxon” banking. The English speakers’ fancy debt products, the reasoning went, had inflated a global asset bubble that, when it burst, damaged France’s and Germany’s banks and, as global trade plummeted, their export-dependent economies as well. By late 2008 and early 2009, the French and German governments were reluctantly spending tens of billions of euros in stimulus funds to insulate their populations from a disaster that had swept across their borders.

British prime minister Gordon Brown initially charged that the crisis “came from America.” But America and Britain had together created and dominated the lucrative world of intricately structured debt securities and derivatives that were at the core of the meltdown. New York financiers had structured complex mortgage-backed securities so that financial institutions could invest in them without putting aside significant capital reserves to absorb potential losses, thus pushing profits higher. London bankers had designed the elaborate “structured investment vehicles” that let the firms hold the securities off their books, further cutting the perceived need for capital. Credit default swaps, the inadequately regulated financial instruments that seemingly allowed financial institutions to transfer the risk of debt securities to trading partners for a nominal fee, were an Anglo-American invention. The American bankers who devised the $500 billion in swaps for the insurance giant AIG—eventually resulting in the U.S. government’s $182 billion bailout of the firm after the guaranteed securities began to go sour—worked out of London.

Britain and America also each saw spectacular commercial-bank failures as the initial housing crisis deepened. While America had subprime mortgages, Britain had “buy-to-let” schemes in which regular people could buy houses on credit, renting them out until they could flip the houses for a hefty profit. Each nation saw a major bank fall because of its overexuberant investments in domestic housing: IndyMac in California and Northern Rock in northeast England. Months later, each country had to take a significant ownership stake in a marquee bank: in the U.S., Citigroup, and in Britain, the Royal Bank of Scotland. And each saw a commercial bank, until then weathering the crisis well, forced to accept government guarantees because of a hasty purchase of a trophy asset: Bank of America with Merrill Lynch and Lloyd’s with the HBOS financial group.

As the crisis worsened, France and Germany seized the moral high ground to pressure America and Britain into major overhauls of financial regulation. “The U.S. will lose its status as the superpower of the world finance system,” said Germany’s finance minister, Peer Steinbruck, in October 2008. Sarkozy promised that la crise would bring an end to financial “laissez-faire,” adding that “a certain idea of globalization is dying with the end of a financial capitalism that had imposed its logic on the whole economy.” The French president pushed for a global summit, winning rough commitments for big changes from London and Washington before President Obama took office. Britain seemed ready to take its lumps. Lord Adair Turner, chairman of London’s Financial Services Authority (FSA; similar to America’s Securities and Exchange Commission), began openly to question whether the financial industry had grown too big and arcane for Britain’s own good. America, too, appeared chastened.

Part of the regulatory solution, European leaders said, would be a new spirit of Europe-wide cooperation on financial rules, with a unified Europe pressing America into regulatory cooperation, too. The crisis had, in fact, exposed a significant weakness in Europe’s own system of nation-by-nation regulation. As was the case with America, Europe had no consistent, orderly way for a big, interconnected financial firm to fail without inflicting damage on the broader economy. The too-big-to-fail problem was actually even worse in Europe. Under the European Union’s “passporting” system, a financial institution could set up shop anywhere within Europe yet still operate under its home country’s regulations. That’s how an Icelandic bank, Landesbanki, could offer Britons online saving accounts under Icelandic rules. But when Landesbanki failed in October 2008, Britain—fearing that panicked citizens would rush to remove their savings not just from Landesbanki but from British banks, too—had to step in and save depositors, despite having had zero say in regulating the massively over-leveraged foreign-based firm.

A high-level European Commission report in February 2009 suggested that Europe adopt “a more harmonized set of financial regulations, supervisory powers, and sanctioning regimes” and floated the idea of a Europe-wide supervisory body. The European lawmakers presented legislation on this front in late September 2009. Such a body would leave day-to-day regulation up to national bodies, but it might be able to punish national regulators and companies for failing to adhere to rules. This would represent a break from the current system, called Basel, a two-decade-old agreement among Europe, the United States, and the rest of the developed world in which execution, regulation, and enforcement of global guidelines are voluntary and happen on a national basis.

Even fiercely independent Britain—it doesn’t use the euro common currency—at first seemed open to the change. A month after Europe released its report, the FSA unveiled a 126-page blueprint for reform, expressing a “preference” for a “new European Union institutional structure . . . an independent authority with regulatory powers,” to address the complex problems of cross-border bank failures and other issues. One experienced observer, Bob Penn, a partner at London’s Allen & Overy law firm, noted that “the real surprise is in the FSA’s willingness to give up powers to Europe. This would have been unthinkable a year ago and is a politically brave recognition of the need for international solutions to international problems. However, the devil will be in the detail of negotiating how far real powers will be ceded to Europe.”

Indeed. The problem with regulatory “harmonization” with teeth is that there really is no “Europe” but only a collection of competing nations—and what they’re competing for is finance jobs. Over the half-decade leading up to the current crisis, the business of high-end finance led GDP in Europe, growing at 4.6 percent each year, double the general growth rate. And each European economy wants that growth to lead its own economy. So while Lord Turner, the FSA chairman, may create an international frisson for musing over the summer that a global transactions tax might be necessary to shrink the “swollen” financial industry (with agreement from Steinbruck, the German finance minister, in September 2009), Europe’s national leaders were thinking: Sure, let it shrink, just not in my country.

To see how quietly fierce the competition over finance is, consider France, which is salivating over London’s financial jobs. Paris believes that it has room for finance to grow, since the U.K. has dominated the high-end sector in recent years, claiming more than a third of Europe’s best finance jobs, leaving France with only 10.7 percent and Germany, with its own ambitions, 13.1 percent, according to a study commissioned by the City of London. The French plan an expansion of La Defense, Paris’s high-rise financial district, to become a “rival to the City of London,” says Sarkozy’s minister in charge of the project.

The British understand that Sarkozy’s main problem with “Anglo-Saxon finance” is that there’s not enough of it in Paris. During a September visit to New York, London mayor Boris Johnson noted France’s covetousness and pointed out, deadpan, that Britain is home to a factory that exports chocolate cake and brownies—to France. “I say to Mr. Sarkozy, before you further desire our financial industry, you had better have a look at your cake business,” Johnson said.

Britain has a reason beyond French rivalry to preserve its discretion over financial regulations: its own history of successfully exploiting regulatory differences between nations. Some in the City—London’s financial district—remember that, decades ago, London bankers’ savvy perception of a potential profit machine, accidentally created by bad policy in Washington, gave London a coup over Wall Street. In 1963, Washington was worried that too many foreign companies were coming to New York to take advantage of easy debt markets, fueling speculation. So President Kennedy imposed an extra 15 percent tax on the interest that investors got from bonds issued in America by foreign borrowers. This clumsy effort proved only that global companies, seeking to borrow money in dollars from investors who wanted to lend in dollars, would do so wher-ever they could—in this case, leaving America, and New York’s financial markets, entirely out of it. One British investment house, S. G. Warburg, created from scratch a London-based market in dollar-denominated bonds that attracted billions from global investors, as Ron Chernow observed in his biography of the Warburgs. The market outlasted the tax, which died after 11 years. London’s prowess in foreign-currency bonds means that even today, the City markets more international bonds in euros than any euro nation does.

But the biggest problem with the most sensible financial-regulatory fixes (and this is true of the not-so-sensible ones, too) is that each hurts one nation more than it hurts others. In May, the European Parliament unveiled its first ambitious postcrisis proposal to regulate financial markets more extensively, and it seemed designed to aggravate Britain’s fear of disadvantage through blunt regulation. The proposed “directive” would closely regulate hedge funds, private equity funds, and other management funds, but exempt funds owned by big banks. The directive would impose limits on borrowing and on certain securities at investment funds, and it would even restrict fund managers’ right to delegate some responsibilities to overseas entities—to an investment team in Asia, say. Most constricting are the limits on overseas funds’ right to market to European investors. “Stringent conditions will need to be satisfied” for international fund managers looking to market in the E.U., wrote attorneys at the Freshfields law firm. “The E.U. is therefore set to become much less open to non-E.U. managed funds.”

London has the most to lose. The City is Europe’s Number One asset manager, with more than a third of such business across the region. As Mayor Johnson warned, the directive would “sever the transatlantic connection” between London and New York in hedge-fund and other investment management. London is also home to hundreds of stand-alone hedge funds that could find themselves competing at tremendous disadvantage against bank-owned funds on the Continent. Rather than fight a losing battle, the funds might decamp to Switzerland (outside Europe’s regulatory purview), removing their business not just from Britain but from Europe as a whole.

Other Europe-wide regulation could disadvantage France and Germany, whose banks borrow more money to invest but hold less capital to protect from losses. A recent JPMorgan Chase report estimated that, were the eight most commonly suggested regulatory reforms enacted, profitability at the investment-bank division of Germany’s Deutsche Bank “would be the most impacted” compared with the rest of the developed world, with French banks next in line. France’s banks are already resisting stricter capital requirements, arguing that their bankers did relatively well in the recent crisis.

European cooperation on financial regulation won’t work so long as each nation is looking out for its own interest—meaning that it won’t work. The E.U.’s power to impose specific rules and enforce them robustly across what are still national financial markets remains unsettled. While the European Parliament can enact its directive through a vote, it’s up to each nation’s legislature—and then its regulators—to implement it. Take the proposed hedge-fund rule: each nation would need to “transpose” it into domestic law. Though the laws are supposedly consistent “in theory,” says Frédérick Lacroix, a partner at the Clifford Chance law firm in Paris, “there could be discrepancies.” And if Europe tries to force a directive against any powerful nation’s self-interest, there’s a risk that the directive would reveal itself to be a paper tiger.

Creating a European regulator with binding arbitration powers, as the European Commission’s report has proposed, wouldn’t be easier. “The biggest issue is authority,” says Lacroix. The E.U., under the treaty that governs its existence, can police markets for anticompetitive behavior—huge state subsidies to national champions, for instance—and it can enforce adherence to broad principles. Yet without precedent or explicit permission in the European treaty, Europe seemingly lacks the authority to delegate powers to a financial body that could make rules and impose sanctions.

Europe, despite the European Parliament’s push, is already moving to use the usual looser system of global cooperation—the old Basel agreement—to outline broad principles of higher capital requirements and the like, and implement the ensuing guidelines on a national basis. Such a project could take months, if not years, and by itself won’t produce the major changes to the global financial order that Sarkozy dreamed of last year.

Even on the sticky question of what to do with failed cross-border banks, Europe may have to content itself with a situation in which “financial institutions may be global in life . . . but . . . are national in death,” as Thomas Huertas, chief executive of Britain’s FSA, has described them. That may seem untenable, but what’s the alternative? A pan-European regulator with financial resources and real discretionary power over sovereign nations doesn’t seem likely.

Further, the current regulatory environment may not be as bad as it seems. Yes, it’s true that last year, broke Iceland initially refused to pay British depositors under its national deposit-protection plan—but it eventually capitulated, partly because it didn’t want to lose future access to Europe’s lucrative markets. A system of largely informal cooperation based on self-interest may continue to hold. And having too formal a system of rescuing the economy from cross-border failures could cause its own unintended problems. Lenders to financial institutions would know that a strong, unified Europe could more easily bail them out, potentially worsening the too-big-to-fail problem. Regulatory competition also provides an incentive for nations to avoid overregulating and killing off financial innovation, as America did with its tax on foreign borrowing in the 1960s.

Publicly, Europe wants to salvage its image of pristine cooperation. Luckily, there’s that old standby: bankers’ bonuses, not the main problem but a symptom of an inadequately regulated financial system that doesn’t face full market discipline. Ahead of the latest global-leaders summit in September in Pittsburgh, Sarkozy threatened to keep “irresponsible banks” from “returning to bad habits” with bonuses. Gordon Brown promised that there was “no going back to the bonus structure of the past.”

The result was desired headlines, not drastic action. In London, the FSA has added a “Remuneration Rule” to its regulatory code. It requires financial firms to design pay policies consistent with good risk management and to disclose pay policies and ranges broadly. But the rule is notable for its discretion, and for what it (thankfully) doesn’t require: hard caps, which would smack of seventies-style wage and price controls without attacking the reason bonuses got so big in the first place—government subsidy. France has likewise taken no harsh action, doing close to what London has done. Arnaud Bresson, a spokesman for Paris Europlace, which represents France’s private-sector financial industry, says that “these . . . questions must be discussed on an international level.”

This European drama has implications for America—and for New York. Just as London competes warily with Paris, New York competes warily with London. No self-respecting American politician—not even multilateral President Obama—would admit to waiting to see what Europe does before implementing adequate financial regulations at home. But surely Larry Summers, Obama’s chief economic advisor, and others are counseling the president as well as congressional leaders that in the short term, imposing unilateral regulations, such as a requirement to hold significant capital against credit default swaps, would send much of that business to a willing country that’s a five-and-a-half-hour flight away. The proposed bonus rules that the Federal Reserve announced just weeks after Britain’s “Remuneration Rule” went into effect are remarkably similar to the mild British restrictions. Despite Sarkozy’s declaration in late September, after the latest global summit, that “there is no longer an Anglo-Saxon world and a European world,” the bonus agreement ironed out at the summit was so vague that it seemed designed to distract from the real issues and let everyone go on largely as before, after a polite interval.

The impulse not to act unilaterally is understandable. Yet absent adequate regulation that makes markets robust enough to withstand failure, European nations—and America—are competing, not healthily on subtle differences, but unhealthily on how much implicit government subsidy they can offer an inadequately regulated, too-big-to-fail financial system. So far, no nation has credibly disavowed the notion that its financial sector can continue to expect bailouts in future crises. A credible system to enforce market discipline on financial firms would require national regulations that make it easier for financial markets to withstand failure, including limits on borrowing and mandates for financial instruments—such as credit derivatives—to trade on central exchanges. Because lenders to financial institutions are confident that a national government will bail them out, they continue to lend at lower rates—thus providing the subsidy.

Continuing to subsidize the financial sector carries long-term costs. A government-supported financial sector competes with other, perhaps more productive, areas of the economy for resources. Further, a financial-sector bubble based largely on implicit government guarantees can encourage governments to hike spending to profligate levels. And because the political will to cut spending in a downturn is usually lacking, tax increases then become almost inevitable. New Yorkers understand how this works. The British do, too: Britain has already hiked its top income-tax rate to 51 percent, effective next year, giving France a competitive opening.

Finally, the bigger any nation’s financial sector grows, the harder it becomes for that nation to bail it out. In autumn 2008, Iceland couldn’t save its own financial sector, the debt of which had reached nearly ten times GDP; it had to let its banks fail. Britain and the U.S. aren’t there yet; their bailouts seem to have “worked.” But if they continue to send the implicit message to financial firms that a government bailout is always available upon request, someday they will get there—through a sovereign debt crisis.

The United States should not allow a global regulatory stalemate to prevent it from creating a credible way in which lenders to its financial institutions can take their losses, including smarter capital requirements and rules for unregulated financial instruments (with regulatory competition overseas usefully keeping us from going too far) to make the system more robust.

Such action could reap unexpected benefits. If Europe’s financial institutions don’t feel intense pressure to compete against institutions headquartered in a nation with the most national resources to offer bailouts, they may be more amenable to reasonable regulations at home. As usual, it’s a question of short-term trade-offs versus long-term principle. The political class is good at making the short-term trade-offs. So it doesn’t hurt for the rest of us to direct their view toward the principle: creating the conditions for a competitive financial sector, not a government-coddled one.

Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst and the author of the forthcoming After the Fall.

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