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Fool Me Once…


Bob Eisenbeis

I don’t normally pen an economic commentary on an article that has appeared elsewhere, but David Enrich’s Wall Street Journal article of February 17, 2011, entitled “Banks Find Loophole on Capital Rule,” raises some important concerns and is worthy of additional observations. The article notes that Barclays changed the legal classification of its main US subsidiary so as to no longer be subject to US bank capital standards. Enrich goes on to state that several other institutions, including Deutsche Bank and other foreign primary dealers, may be also considering such changes. Two points are worth noting. First, regulatory arbitrage is alive and well. Institutions have begun actively seeking ways to avoid the new capital standards, even before they are put in place. Second, such actions are inconsistent with the primary thrust of the proposed new Basel III capital standards that attempt to restore a meaningful 4 percent Tier 1 minimum capital ratio and to impose even higher standards on systemically important institutions.

The WSJ goes on to mention another worrisome issue. It reports the capital ratios for several institutions whose US holding companies fail to meet the US requirements. Deutsche Bank’s Taunus subsidiary allegedly has negative capital. The US holding company subsidiaries of Barclays, Toronto-Dominion Bank, and Rabobank Group fall below the new Tier 1 leverage ratio of 4%, while HSBC is just slightly above that threshold.

These are troublesome statistics, especially in view of the injection of home-country taxpayer funds into such institutions during the financial crisis. They raise substantive questions about what their home-country regulators are actually doing at this point to shore up their institutions’ capital positions. Why would they even contemplate accommodating a change in status if it meant perpetuation of further weakened capital positions, especially given the thrust of the new Basel III capital standards?

The Federal Reserve is certainly not helpless in dealing with such changes, and one hopes to see new standards emerging from the Fed promptly. Deutsche Bank, Barclays, and HSBC are primary dealers. Remember that the primary dealers are supposed to be the soundest institutions. They are market makers in Treasury obligations, participate in Treasury auctions, and are authorized to deal directly with the Federal Reserve System Open Market Account as the Fed conducts its daily open-market operations. Remember that some primary dealers, including Bear Stearns, Countrywide, Merrill-Lynch, and Lehman Brothers, either failed or were merged because of financial difficulties; and others such as Deutsche Bank, BNP Paribas, Citigroup, Goldman Sachs, Morgan Stanley, Royal Bank of Scotland, and UBS were recipients of government-sponsored rescues and injections of taxpayer funds. They apparently fooled the Federal Reserve into believing they were in much better financial shape than they actually were.

The Federal Reserve should step forward and put a stake in the ground when it comes to actions by Barclays and others to avoid having their US subsidiaries meet US capital standards. It would be a simple matter for the Fed to require that primary dealers and their affiliates and subsidiaries operating in the US meet minimum capital standards. Any actions to avoid them should result in revocation of primary dealer status. During the financial crisis, Barclays, Deutsche Bank, and others were significant beneficiaries of the Fed’s emergency Primary Dealer Credit Facility and US taxpayer subsidies inherent in that support. It is time for the Fed to put teeth in its capital programs and use whatever leverage is available, especially when it comes to foreign institutions, to ensure that it is truly dealing with sound financial institutions. The Fed may claim to have been fooled by the dealers once. If so, then shame on the dealers. But the Fed should not risk being set up to be fooled twice.

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