Will the Next Banking Crisis Originate in Europe?

The subprime mortgage crisis has been daily news for many months. The Federal Reserve has lowered interest rates a number of times. Bear Stearns (BSC) collapsed and was absorbed by JP Morgan (JPM). E-Trade (ETFC) survived, but barely. Shares of subprime lenders like Countrywide (CFC) lost substantial value, as well as many big names in the banking industry, including Citigroup (C), Wachovia (WB), and Bank of America (BAC)--which is now acquiring Countrywide--and speculation continues as to how much worse it will get. However, with all the focus on the domestic credit crisis on Wall Street, investors may overlook another danger lurking from the other side of the Atlantic.

Complaints about lax regulation of the U.S. financial industry have become commonplace. But relative to Europe, the domestic industry is more strictly regulated: National banks are regulated by the Federal Reserve and the OCC (savings associations by the OTS and credit unions by the NCUA; state banks are regulated by the states’ pertinent overseeing agencies) and further by the FDIC where deposits are insured; and the securities business is regulated by the SEC. The banking and the securities business are two separate sectors of this country’s tripartite financial services system (the third sector is the insurance business, which is state-regulated).

This segregation stems from the concern that allowing banks to speculate with securities without proper restrictions can lead to a financial crisis, which many believe was a leading cause of the market crash in 1929 and the following Great Depression (admittedly, the Gramm-Leach-Bliley Act of 1999 somewhat blurred the lines by allowing “Financial Holding Companies” to hold banks alongside other businesses dealing in securities or insurance, but the basic system remains).

Europe also defines financial business by these three categories, but Europe’s Second Banking Directive specifically allows banks to trade securities for their own account and for its customers, participate in issuing shares, and engage in portfolio management and advice--in addition to the traditional banking activities (which are mostly deposit taking and mortgage credit). This year’s éclat caused by rogue trader Jérôme Kerviel at Société Générale illustrates pertinent dangers well.

Financial services regulation is already weaker in Europe than in the United States partly because of the (formerly) less aggressive business culture in most of its countries. And the unification of Europe may now further cause a regulatory race to the bottom: The Second Council Directive prohibits its countries from requiring authorization or endowment capital for branches of credit institutions authorized in other member countries. The idea is that only a single banking license is required for the entire European Union. Add to that that Europe decided to rely on minimum floors while requiring reciprocal treatment in its effort to harmonize its countries’ regulations, and the problem becomes transparent:

Lowest-common-denominator-like minimum standards are probably inadequate in themselves, and since member countries must recognize each others’ regulations and cannot discriminate against each other, an institution chartered in one country and conducting business in another may not be required to satisfy higher standards than other institutions that are chartered in the foreign country, or what the institution’s home state requires (this is known as “mirror-image” reciprocity).

At the same time, each country is interested in keeping or attracting financial institutions in/to its jurisdiction (as it can charge fees for the bank charters and tax revenue gained by the institution, and further benefits from the employment the financial business brings to the country), and an easy way to do so is to offer a loose regulatory regime with low capital requirements and little restrictions on the type of activities an institution may engage in. (For comparison, deregulation of restrictions on banking activities in the U.S. were, at least in part, also caused by federal and state agencies competing for jurisdiction over financial institutions.)

On the other hand, clinging to strict regulations becomes a forlorn strategy for a European country, as it must honor another country’s looser regulations anyway. If all member states draw this conclusion, the result is that eventually none of them will require more than the bare minimum. Indeed, George Zavvos of the Directorate for Financial Institutions in Brussels writes that “there is a justified expectation that the new Community strategy enshrined in the Second Directive will have a major deregulatory impact on the most restricted banking systems in the Community.”

Last year, European finance ministers met to consider weakening the power of individual central banks of its member states even further. In an effort “to limit political interference in bank takeovers and [to] make payments within the EU easier,” the EU plans to limit its member states’ central banks’ ability to “prevent [takeover] deals.” Currently, at least “[s]ome central banks can . . . prevent--or at least delay--deals if they believe the new buyer of a bank could damage the financial stability of their country. ... The new rules aim to limit that.”

Europe’s financial business is also becoming increasingly aggressive. A few years ago, The New Republic already speculated that “the next Enron will probably occur [in Europe.]” As proof of a clash between this new style of business and weak regulations, The New Republic cites the 2003 scandal of Italy’s food giant Parmalat (Parmalat founder Calisto Tanzi admitted to stealing €500 million from the company and transferring it to business owned by his family; Parmalat eventually collapsed when it was discovered that a bank account thought to hold about $5 billion did not exist). In the wake of the Parmalat scandal, the chief financial regulator of the European Commission, Frederick Bolkestein, warned the European parliament that “the financial business industry had better get its act together and do so fast.”

U.S. financial institutions do business in less regulated Europe, where they are allowed to take greater risks than they would in the U.S. Indeed, two of the financial institutions affected by the European Parmalat scandal were Bank of America (BAC) and Citigroup (C). In theory, the United States could impose stricter regulations on its institutions in the foreign markets, but the Federal Reserve’s Regulation K allows U.S. banks to exercise such powers overseas as are usual in the banking business in the place where the branch is located, in order not to impede their chances to compete with local business. For example, Reg. K allows U.S. banks and holding companies to underwrite and deal in securities outside the United States, similar to Europe’s Second Banking Directive. Hence, when picking financial stocks, it may be worth to look beyond the domestic crisis and watch out for the institutions’ activities overseas.

Disclosure: The author owns ETFC.

References:

• Second Council Directive of 15 December 1989 on the coordination of laws, regulation and administrative provisions to the taking up and pursuit of the business of credit institutions and amending Directive 77/780/EEC, O.J. Eur. Comm. (No. L. 386) 1, art. 6 no. 1 (1989) (Council Directive 89/646/EEC), available here.
• George Zavvos, Doing Business In The European Internal Market: Banking Integration in the European Community, 9 Nw. J. Int’l L. & Bus. 572, 574 (Winter 1989).
• Finance Ministers Discuss Euro Economy--Finance Ministers From Euro Nations See Brighter Prospects For Their Own Economy Before Talks, Associated Press, Mar. 26, 2007.
• Clay Risen, "Accounts Due", The New Republic, Mar. 29, 2004, at 18.
• Eric Sylvers, "Parmalat Trial Opens, and Quickly Adjourns", NYTimes.com, Sept. 30, 2005.
• Eric Sylvers, "Judge in Italy Sentences 11 in Collapse of Parmalat", NYTimes.com, June 29, 2005.
  
• David Rae, "Grant Thornton SpA chairman goes over Parmalat", AccountacyAge.com, Jan. 2, 2004.
• Joel P. Trachtman, Recent Initiatives in International Financial Regulation and Goals of Competitiveness, Effectiveness, Consistency, and Cooperation, 12 Nw. J. Int’l. L. & Bus. 241, 267-71 (Fall 1991).
• Caroline Bradley, The Case of Financial Services, 12 Nw. J. Int’l L. & Bus. 124, 125 (Spring/Summer 1991).
• For the Société Générale scandal, see here.
• For Bear Stearns, see here.

Comments

[dan clue:]

Look for the worst to be over at Etrade. The only thing thats holding back their shares is the analysts. Etrade went from writing off 1.7 billion in the 4th quarter to losing 90 million in the first quarter. What I find odd was in the 1st quarter Etrade socked away an additional 234 million in cash into their future or potential loan loss fund, increasing this fund to over 700 million so technically it wasn't a loss in the first quarter. The analysts work for companies that has wrote off billions in the 4th quarter and billions in the first quarter, I think they should be using etrade model.

2008 Apr 23 09:10 AM

[dan clue:]

Has anyone noticed that Etrade is buying up alot of their shares? They own over 6%. They purchased an additional 1% of the last week.

2008 Apr 23 09:57 AM

[H2O:]

Enter your comment hereCNN site hit by China attack

You know whats really amazing about the rich-greedy - golden calf-builder - worlds ours dom manidestos????

They really are stupid IDIOTS - thats why GOD was able to destroy so easy - The really do think - stick don't stick to there shit, somebody else stunk up the bathroom.

cyber war-fair, damn the easist think in the world to defend against.

Shall we tell them, NAAAA don't think so - but we will say - instead of CNN - it's a clinton bush - the rich-greedy dribing up the price of oil on you, and if they nuke IRAN - what price would it be now????

so wrong place your attacking!!!!!!

Saving American JObs - just insures - you have a place to sell at, dumbasses - your like a farmer on the side of the road selling weeds - if Americans don't have jobs.

attack again, there will be little choice but to show the IDIOTS how to counter it.

You should be supporting change - and keeping the American buyers, that is unless - your past your countries evolution and giving away your past, for there visions.

aqctually what i would do is start selling - the dollars. and buying euros, if the dips are set on there world manidestos, be in a good position - to team up with russia - to buy europe , and buy just about anything in america they stole, after all Native Americans say they came from there, no need for a war to geyt it back, just buy it.



~WARRIOR~

2008 Apr 23 08:46 PM

[H2O:]

What is that bilbical saying? those who control the flow of goods and food, control the world????

damn - talk about enough rope to hang yourself with.

2008 Apr 23 08:53 PM

[mlimberg:]

And now, something real important....

NEW YORK (CNNMoney.com) -- Among the nightmares lurking around the corner for the already battered housing and credit markets would be a meltdown at mortgage financing giants Fannie Mae and Freddie Mac.
Although few are predicting an imminent need for a bailout just yet, credit rating agency Standard & Poor's recently placed an estimated price tag on this worst case scenario -- $420 billion to $1.1 trillion of taxpayer's money.
This dwarfs how much it cost to help banks during the savings and loan crisis of the late 1980's and early 1990's. That cost taxpayers about $250 billion in today's dollars.

Has anyone added all the lost money and compaired that to the perceived worth of the world? What % of the beleive wealth of the world is the loss we have seen and the loss not yet reported? At some point we may have spent all our wealth?

Time to go back to the gold standard....

2008 Apr 24 09:30 PM