Since the start of the Global Financial Crisis back in 2008, European and US policymakers and regulators have blamed the international banking system for systemic risks and abuses. Regulatory and supervisory authorities have begun designing and implementing system-wide responses to the causes of the crisis. What emerged from these efforts was an explosion of regulatory authorities. Regulatory, supervisory and compliance jobs mushroomed, turning legal and compliance departments into a new Klondike, mining the rich veins of regulations, frameworks and institutions. The edifice, it was presumed, would address the causes of the recent crisis and create systems that can robustly prevent future financial meltdowns.
At the forefront of these global reforms are the EU and the US which took two distinct approaches to beefing up their responses to the systemic crises. Yet, the outrun of the reforms is the same.
The US has adopted a reform path focused on restructuring of the banks – with the 2010 Dodd-Frank Act the cornerstone. The capital adequacy rules closely followed the Basel Committee which sets these for the global banking sector. The US regulators have been pushing the folk at Basel to create a common ‘floor’ or level of capital a bank cannot go below. Under the US proposals, the ‘floor’ will apply irrespective of its internal risk calculations, reducing banks’ and national regulators’ ability to game the system, while still claiming the banks remain well-capitalised. Beyond that, the US regulatory reforms primarily aim to strengthen the enforcement arm of banking supervision. Enforcement actions have been flying since the ‘recovery’ set in, in 2010.
Meanwhile, the EU has gone about the business of rebuilding its financial markets in a traditional, European, way. Any reform momentum became an excuse to create more bureaucratese and to engineer ever more Byzantine, technocratic schemes in the hope that somehow the uncertainties created by the skewed business models of banks get entangled in a web of paperwork, making the crises if not impossible at least impenetrable to the ordinary punters. Over the last eight years, Europe created a truly shocking patchwork of various ‘unions’, directives, authorities and boards – all designed to make the already heavily centralised system of banking regulation even more complex.
The ‘alphabet soup’ of European reforms includes:
• the EBU and the CMU (the European Banking and Capital Markets Unions, respectively);
• the SSM (the Single Supervisory Mechanism) and the SRM (the Single Resolution Mechanism), under a broader BRRD (Bank Recovery and Resolution Directive) with the DGS (Deposit Guarantee Schemes Directive);
• the CRD IV (Remuneration and prudential requirements) and the CRR (Single Rule Book);
• the MIFID/R and the MAD/R (enhanced frameworks for securities markets and to prevent market abuse);
• the ESRB (the European Systemic Risk Board);
• the SEPA (the Single Euro Payments Area); • the ESA (the European Supervisory Authorities) that includes the EBA (the European Banking Authority);
• the MCD (the Mortgage Credit Directive) within a Single European Mortgage Market; the former is also known officially as CARRP and includes introduction of something known as the ESIS;
• the Regulation of Financial Benchmarks (such as LIBOR & EURIBOR) under the umbrella of the ESMA (the European Securities and Markets Authority), and more.
The sheer absurdity of the European regulatory epicycles is daunting.
Eight years of solemn promises to end the egregious abuses of risk management, business practices and customer trust in the American and European banking should have produced at least some results when it comes to cutting the flow of banking scandals and mini-crises. Alas, as recent events illustrate, nothing could be further from the truth.
America’s Rotten Apples
In the Land of Freedom [from individual responsibility], American bankers are wreaking havoc on customers and investors. The latest instalment in the saga is the largest retail bank in North America, Wells Fargo.
Last month, the US Consumer Financial Protection Bureau (CFPB) announced a $185m settlement with the bank. It turns out the customer-focused Wells Fargo created over two million fake accounts without customers’ knowledge or permission, generating millions of dollars in fraudulent fees.
But Wells Fargo is not alone.
In July 2015, Citibank settled with CFPB over charges that it deceptively mis-sold credit products to 2.2 million of its own customers. The settlement was many times greater than that of Wells Fargo, at $700m. And in May 2015, Citicorp, the parent company that controls Citibank, pleaded guilty to a felony manipulation of foreign currency markets – a charge brought against it by the Justice Department. Citicorp was joined in the plea by another US banking behemoth, JPMorgan Chase. You heard it right: two of the largest US banks are felons.
And there is a third one about to join them.
This month news broke that Morgan Stanley was charged with “dishonest and unethical conduct” in its dealings in Massachusetts securities “for urging brokers to sell loans to their clients”.
A snapshot of the larger cases involving Citi and its parent company shows they have faced fines and settlement costs of over $19bn between 2002 and 2015. Today, the CFPB has over 29,000 consumer complaints against Citi and 37,000 complaints against JP Morgan Chase outstanding.
Citi was the largest recipient of the US Fed bailout package that followed the 2008 Global Financial Crisis. It obtained heavily subsidised loans totalling $2.7tr or roughly 16 percent of the entire bailout in the US.
But there have been no prosecutions of Citi, JP Morgan Chase or Wells Fargo executives.
Europe’s Ailing Dinosaurs
This state protection is matched in the case of another serial abuser of market rules: Deutsche Bank.
According to US Government Accountability Office (GAO) data, during the 2008-2010 crisis Deutsche got $354bn of emergency financial assistance from the US authorities. In contrast, Lehman Brothers got only $183bn.
Last month, Deutsche entered into talks with the US Department of Justice over the settlement for mis-selling mortgage-backed securities. The original fine was set at $14bn – enough to effectively wipe out the capital reserves cushion in Europe’s largest bank. Latest financial-market rumours are putting the final settlement closer to $5.4-6bn, still close to one third of the bank’s equity value. To put these figures into perspective, Europe’s Single Resolution Board fund, designed to be the last line of defence against taxpayers’ bailouts, currently holds only $11bn in reserves.
The Department of Justice demand blew Deutsche’s troubled operations wide open. The business model of the bank resembled a house of cards. Deutsche’s problems are threefold: legal, capital, and leverage risks.
The bank has already paid out some $9bn worth of fines and settlements between 2008 and 2015. At the start of this year, the bank was yet to achieve resolution of the probe into currency markets manipulation with the Department of Justice. Deutsche (along with 16 other financial institutions) is also defending a massive law suit by pension funds and other investors. There are ongoing probes in the US and the UK concerning its role in channelling some $10bn of potentially illegal Russian money into the West. The Department of Justice is also after the bank for alleged malfeasance in trading in the US Treasury market.
And in April 2016 the German TBTF (Too-Big- To-Fail) goliath settled a series of US lawsuits over allegations it manipulated gold and silver prices. The settlement amount was not disclosed, but the manipulations involved tens of billions of dollars.
Two years ago, Deutsche was placed on the “enhanced supervision” list by the UK regulators – a list, reserved for banks that have either gone through a systemic failure or are at a risk of such. This list includes no other large banking institution, save for Deutsche. As reported by Reuters, citing the Financial Times, in May this year, UK’s financial regulatory authority stated, as recently as this year, that “Deutsche Bank has “serious” and “systemic” failings in its controls against money laundering, terrorist financing and sanctions”.
As if this was not enough, last month, a group of senior Deutsche ex-employees was charged in Milan “for colluding to falsify the accounts of Italy’s third-biggest bank, Banca Monte dei Paschi di Siena SpA (BMPS)”. Of course, BMPS itself needs a government bailout, as it has been haemorrhageing capital over recent years while nursing a mountain of bad loans. One of the world’s oldest banks, the Italian lender, which has been deemed ‘systemically important’ has been teetering on the verge of insolvency since 2008-2009.
All in, at the end of August 2016, Deutsche Bank is dealing with some 7,000 law suits, according to the Financial Times.
Beyond its legal problems, Deutsche is sitting on a capital structure that includes billions of notorious CoCos – Contingent Convertible Capital Instruments. These are a hybrid form of capital instruments, favoured by European and Irish pillar banks, that are structured to absorb losses in times of stress, by automatically converting themselves into equity. They appease European regulators and, in theory, provide a cushion of protection for depositors. In reality, CoCos hide complex risks and can destabilise those who deal in them.
Moreover, Deutsche’s balance sheet is loaded with trillions of Euro worth of opaque and hardto- value derivatives. At of the end of 2015, the bank held an estimated €1.4tr exposure to these instruments in official accounts. A full third of the bank’s assets is composed of derivatives and ‘other’ exposures, with ‘other’serving as a financial euphemism for anything other than blue-chip, safe, investments.
The Financial Undead
Eight years after the blow-up of the global financial system hundreds of tomes of ‘reform’ legislation and rule books have been thrown at the crumbling façade of the global banking system. Tens of trillions of dollars in liquidity and lending supports have been pumped into the banks and financial markets. And there are never-ending calls from the Left and the Right for Government solutions to banking problems.
Still, the American and European banking models show little real change after the crisis. Both the discipline of the banks boards and the banks’ strategies for rebuilding their profits remain unaltered by the lessons of the crisis. Election after election candidates compete against each other to promise a regulatory nirvana of de-risked banking. And time after time, as the electoral smoke dissipates, the grossrisk- neglecting system subsists, disregarding customers on the implicit assumption that, if things get hot again, taxpayers’ cash will rain on the fires threatening the too-big-to-reform banking giants.
By Constantin Gurdgiev