What if Other Nations Don't Regulate Banks Like the U.S. Will?

After President Obama signs the new financial regulation bill this week, the U.S. will lead the way in new regulatory barriers that banks face. Proponents of the legislation believe that this will provide U.S. financial institutions with the advantage of being safer and sounder than their foreign counterparts. But skeptics think overly aggressive regulation might hurt U.S. competitiveness in financial services. A Senate subcommittee hearing today addressed this topic, and a few witnesses did express some concern.

In prepared testimony, Federal Reserve Governor Daniel Tarullo said that some elements of the Dodd-Frank bill would almost certainly be coordinated on a global basis, like capital requirements. But he worried about other parts:

At the same time, there are aspects of the Dodd-Frank Act that are unlikely to become part of the international financial regulatory framework. For example, the act generally prohibits U.S. banking firms (and the U.S. operations of foreign banking firms) from engaging in proprietary trading and from investing in or sponsoring private investment funds. The act also prohibits U.S. depository institutions from entering into certain types of derivatives transactions. In the United States, activity restrictions have long been a part of the bank regulatory regime, serving to constrain risk-taking by banking firms, prevent the spread of the market distortions caused by the federal bank safety net to other parts of the economy, and mitigate potential conflicts of interest generated by the combination of banking and certain other businesses within a single firm. Many other countries follow a universal banking model and are unlikely to adopt the sorts of activity restrictions contained in the act.

Senator Evan Bayh (D-IN) asked Tarullo about this statement, questioning the implications for U.S. competitiveness. Tarullo said it's too early to tell whether such regulations would hurt U.S. banks. He did cite the hope that global investors would perceive U.S. institutions as more stable due to these new regulations, which would actually provide a competitive advantage.

Yet, it's hard to see why global investors would view the bank proprietary and derivative trading limits as strengthening stability. Sophisticated market participants know that these factors, actually had very little to do with the financial crisis. Instead, they served as way for banks to enhance their profits. Without foreign financial institutions adopting prop trading standards and derivative trading restrictions, investors will likely anticipate those firms as exhibiting similar stability as their U.S. counterparts, but having greater profit potential. If that's not a competitive advantage, it's hard to imagine what is.

Bayh also asked another witness, Securities and Exchange Commissioner Kathleen Casey, about the potential competitiveness issues regarding the new regulation of the over-the-counter derivatives market. He wondered what the consequences for U.S. financial markets would be if their global counterparts adopt different standards for the treatment of end users. Casey replied:

I think that it could have significant implications with respect to the competitiveness of our firms, potentially.

She went on to say that regulators are doing their best to coordinate with other nations on issues like derivatives with other nations, though such negotiations are still underway. She did admit that the burden of a higher cost of financing due to derivatives use would hurt U.S. firms if international coordination is not effective.

As Tarullo alludes to, the more controversial regulatory changes are those where global cooperation is less likely. Those which are more widely viewed as sensible, like higher capital requirements for banks, are far more likely to be accepted by other nations. And such more easily agreed to changes should provide the stability that global investors are looking for, while much of the more aggressive regulation was politically motivated.

The trick, then, for the U.S. to maintain its competitiveness in financial services will be to somehow convince all major nations to accept the more aggressive regulations. That won't be easy, since the U.S. has already moved its chess piece. During the conference committee, Republicans tried to create provisions within some of the more controversial measures that would put them into effect only after at least majority of G-20 nations adopted similar changes. Democrats rejected the suggestion, however. For now, U.S. banks will have to hope that other countries don't ignore controversial regulatory efforts like those mentioned above, and view now as a time to capitalize on the U.S.'s overregulation of finance.