Demystifying the Transatlantic Debate

Global Risk 2014-2015

By Gerold GrasshoffThomas PfuhlerNorbert Gittfried, and Filip Saelens

Maintaining a level playing field—especially between the home markets of U.S. banks and their European counterparts—has long been a central argument against regulatory reform. Among the many approaches to this debate, we have chosen the leverage ratio and bank separation rules for a first and basic discussion of a level playing field on the group level.

Leverage Ratios

With Basel III, a global baseline for leverage has been introduced for the first time.1 1 Prior to Basel III, only Switzerland, Canada, and the U.S. used stand-alone leverage-ratio limits. Notes: 1 Prior to Basel III, only Switzerland, Canada, and the U.S. used stand-alone leverage-ratio limits. Increasingly, the ratio of Tier 1 capital to total exposure is considered a crucial regulatory tool, functioning as a backstop to risk-related measures.

Prior to Basel III, leverage measurement had been based largely on accounting numbers. Since U.S. accounting standards allowed for more favorable netting of derivatives than did International Financial Reporting Standards, U.S. banks were able to indicate higher leverage ratios. Also on a comparable basis, after accounting for this effect, U.S. banks historically showed higher leverage ratios than European banks.

This situation could have been the result of enhanced adaptation due to the historical use of leverage ratios, the decision not to adopt Basel II in the U.S., or the lower level of bank debt on U.S. banks’ balance sheets due to their stronger capital-market orientation.

Since the introduction of Basel III and the final proposals for the leverage ratio published by the Basel Committee, both U.S. and European banks seem set to apply the same leverage rules. However, the latest U.S. legislative update, the Enhanced Supplementary Leverage Ratio, introduced three major and potentially sizable differences:

  • There are significantly higher minimum levels—5 to 6 percent compared with the Basel Committee’s proposed 3 percent. In Europe, final minimum levels are not expected until 2017.
  • The leverage ratio is to be calculated on the basis of 90-day daily exposure averages, while current drafts in Europe adhere to the Basel Committee’s standard, based on the average of three month-end exposures.
  • The leverage ratio is part of the regular U.S. stress-testing exercise with minimum levels of 3 to 4 percent under stress. In Europe, no such requirement is planned yet.

On the basis of this current state of leverage rules, it can be debated whether U.S. banks will be at a disadvantage relative to European banks.

Bank Separation

Unlike Europe, the U.S. has no comprehensive separation initiatives on the table. Instead, the U.S. has three sets of regulations, which, together, affect separation.

The recently adopted Volcker Rule bans proprietary trading and funds sponsorship, while the so-called swap-push-out rule requires banks to spin off specific speculative derivatives businesses into separate entities. These two measures are supported by the broker-dealer requirements embedded in the Securities Exchange Act of 1934, which requires banks to set up separate entities for specific trading activities.

In theory, the broker-dealer requirements allow specific trading activities to remain in the core bank. In practice, the decision whether to place these activities in the core bank or with the broker-dealer is product specific. For example, the placement of derivatives business in the core bank could be debated for practical reasons.

In Europe, several national separation laws are already in force. These require only the separation of a bank’s high-risk activities from its deposit-taking activities, and could, therefore, be considered less strict than the U.S. regime. In contrast, the EU separation proposal intends to ban proprietary trading and fund sponsorship and is analogous to the U.S. Volcker Rule. Moreover, the regulator has been granted leeway to demand separation of other risky trading activities such as market making. Depending on the regulator’s discretion, this could result in separation that is higher or lower than that of the U.S. regime.

Although the combined U.S. regime once appeared stricter than Europe’s individual national initiatives, it is debatable whether post-Barnier separation regimes will establish a level playing field. Still, conclusions need to be made very specifically on the basis of individual banks’ business models and product offerings. The same message holds true when taking the UK’s Vickers approach into consideration.

Besides these regulatory issues, other potential distortions to a level playing field include restrictions on bank operations on a regional rather than group level and such market-related concerns as discrepancies in banks’ earning capacity and funding advantage. These issues merit demystifying in a future assessment.