Updated January 11th, 2024 at 22:06 IST
Wall Street brings gun to Basel knife-fight
Banking institutions took regulatory medicine early after the 2008 meltdown, in large doses.
- 6 min read
Basel faulty. When asked why big U.S. banks have grown so much fatter than European rivals since the financial crisis, American executives tend to give a stock answer. Their institutions took regulatory medicine early after the 2008 meltdown, in large doses. But having sailed through a lesser industry blow-up in March last year, JPMorgan CEO Jamie Dimon and his peers are furious about the prospect of swallowing another very bitter regulatory pill. The danger is that they overplay a strong hand.
Dimon and his fellow bosses, including Citigroup’s Jane Fraser and Goldman Sachs’ David Solomon, argue at every opportunity that the package known as the “Basel Endgame” is an unjust disaster. The new rules, which were designed by global watchdogs, adapted by U.S. regulators last July and are set to be finalized in 2024, would make them hold a lot more capital. They are threatening therefore to cut back on services like mortgage lending that support the economy. Banks’ gripes are amplified by lobby groups like the Bank Policy Institute, which has created TV ads demanding regulators “Stop Basel Endgame.”
It may seem insincere for CEOs paid upwards of $30 million a year and their highly remunerated lobbyists to fret about the fate of farmers and low-income shoppers. Analysts expect the largest six firms, which also include Bank of America, Wells Fargo and Morgan Stanley, to report over $120 billion of earnings for 2023. Nevertheless, the banks have solid logical reasons to resist Basel. The rules are in parts unnecessary, overly complex and would needlessly hand business to less sturdy rivals.
The first reasonable point is that U.S. regulators already say the largest firms are ship-shape. Federal Reserve Governor Jay Powell and his counterparts at the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency have repeatedly advised that banks are safe and well-padded against disaster. While lenders would benefit from even plumper cushions, it’s hard to justify an overhaul that would increase the amount of capital the average corporate and investment bank must hold by around one-third, according to an analysis by Oliver Wyman and Morgan Stanley.
In some areas, the Basel framework promotes complexity over quality. One of the most hated parts of the new regulation is its treatment of what’s called operational risk, which broadly speaking encompasses costs incurred from human error, ineptitude, and bad behavior. The proposed rules factor this in by adding a new chunk to banks’ risk-weighted assets, the denominator for capital adequacy calculations, based on a broad measure of income that includes fees and services. The figure includes a multiplier that gets bigger as the banks grow larger, and rises in proportion to historical operational losses, including fines and settlements.
Operational risk accounts for four-fifths of the increase in risk-weighted assets that will come from the Basel rules, according to PricewaterhouseCoopers. That will land heavily on banks like Morgan Stanley and Goldman Sachs, which have pushed into less capital-intensive activities like wealth management and M&A advice. But the income measure is crude, treating all kinds of services equally and counting revenue rather than profit. U.S. regulators are also being far tougher than those in other regions. Authorities in the United Kingdom and European Union have proposed effectively ditching the multiplier for operational risk, meaning that historical losses play no role in the calculation.
The Basel rules also clash unhelpfully with some existing U.S. regulations. There’s the suggestion that banks automatically treat companies which do not have publicly traded securities, like listed shares, as highly risky. European banks can base their assessment on credit ratings from an agency like Moody’s or Fitch. But the Dodd-Frank reforms of 2010 forbid U.S. regulators from using credit ratings in bank rule-setting. Eschewing ratings makes sense, but when combined with Basel it brings unintended consequences. For example, it would make providing short-term financing for huge, safe pension funds vastly more expensive.
Elsewhere there’s the whiff of duplicating existing safeguards. The Basel rules will add extra charges for market swings that might happen in a severe crisis. Yet big U.S. banks already have a stress capital buffer based partly on a theoretical market rout. The regulators don’t have to make the buffer part of the calculation that binds the largest banks, but have proposed doing so anyway.
Mega-banks might be less livid if the rules applied equally to all lenders. Yet the regulations cooked up in Washington will apply to U.S. banks even in foreign countries where local rivals work to a different standard. The same piece of business could therefore lead to a far higher capital allocation for Morgan Stanley than for BNP Paribas, say. Oliver Wyman and Morgan Stanley calculate that $35 billion of annual revenue will move away from U.S. banks. Roughly half of that will flow to European rivals, with the rest shifting to other financial firms, such as private equity groups or specialist lenders.
Making banks more robust is a noble goal – and regulators are not responsible for protecting the industry’s market share. But duplicating existing rules, or putting already well-capitalized banks at a disadvantage to less robust rivals or unregulated shadow banks, is presumably not what the Fed has in mind. Common sense may therefore prevail as regulators absorb industry feedback.
If not, the banks have blunter weapons in their armory. One would be to take the battle to the U.S. courts. Lobbyists have already argued that the Fed hasn’t shown sufficient analysis of the effect of its rules. Some lawmakers are debating whether the Basel framework falls foul of a Supreme Court decision that stops regulators from going too far out on a limb when it comes to “major questions.” Citi’s Fraser admitted during a Congressional hearing in December that such legal challenges were possible. Other executives have said the same to Breakingviews, while stressing it’s not their preferred option.
A legal fight would turn a technical debate into a challenge to the Fed, FDIC and OCC’s ability to set bank rules. The industry might get a favorable hearing from the Supreme Court, some of whose members are skeptical of regulatory power. The catch is that robust regulation has set U.S. banks apart, helped to keep them out of trouble and allowed them to win the trust of clients and investors. The Fed, if it has sense, will water down the Basel rules. Because if the knife-fight escalates then banks, regulators and customers alike will be worse off.
Published January 11th, 2024 at 22:06 IST