by Bill Woodley, Deputy Chief Executive Officer, North America, and Peter Bruzzese, Head of Government and Regulatory Affairs Department, Americas, Deutsche Bank

Disclaimer: Any views and opinions expressed in this article reflect the current views of the authors, which do not necessarily correspond to the opinions of Deutsche Bank AG or its affiliates.

The global nature of modern banking creates the need for an effective global regulatory regime designed to consistently and comparably oversee bank activities. While this notion may seem straightforward, the complexity of the global regulatory environment cuts against it. This is unfortunate because rules that undermine global consistency have consequences for the global economy which impact not only cross-border flows but ultimately impact growth. Therefore, regulatory consistency and cooperation should continue to be encouraged so that banks can compete on a level playing field and be given credit for the strength of their home country operations instead of operating with multiple layers of inconsistent rules that do not meet the goal of creating a safe financial services industry that contributes to economic growth.

Global Regulatory Coordination and Cooperation are Necessary to Support Safety, Soundness and Growth

The safety and soundness of the financial system is a critical objective that must be met to help ensure the success of the global financial system. This view is shared by the G20 leadership as they communicated the efforts that needed to be undertaken to ensure that banks and the banking system would be more resilient. In fact the G20 leadership explicitly stated that they are “committed to take action at the national and international level to raise standards together so that our national authorities implement global standards consistently in a way that ensures a level playing field and avoids fragmentation of markets, protectionism, and regulatory arbitrage,” on page 8 of The Leader’s Statement from the 2009 Pittsburgh G20 Summit. On specific topics – notably capital and liquidity, and central counterparties (CCPs) – the G20’s focus and commitment to harmonization is clear.

For capital, the G20 explicitly said on page 8 of the 2009 Leader’s Statement that building high quality capital involves a commitment to developing internationally agreed rules. Importantly, in the context of the leverage ratio, the G20 made it clear that the details of the leverage ratio should be harmonized internationally, fully adjusting for differences in accounting, and they also committed that all major G20 financial centers should adopt the Basel III Capital Framework by 2011.

Similarly for liquidity, the G20 emphasized in The Leader’s Statement (p.8) that strengthened liquidity risk requirements and forward-looking provisioning not only reduce incentives for excessive risk taking but also create a financial system better prepared to withstand adverse shocks.

With respect to CCPs, the G20 committed in the 2009 Leader’s Statement (p.9) to having all standardized over-the-counter (OTC) derivative contracts traded on exchanges or electronic trading platforms and cleared through central counterparties.

In a similar manner, the benefits of a global approach to recovery and resolution planning were put forth by the Financial Stability Board (FSB) and subsequently endorsed by the G20. This work is especially pertinent to developing a robust Total Loss Absorbing Capacity (TLAC) regime.

Recently the U.S. Department of the Treasury, the European Commission (EC), and the European Securities and Markets Authority (ESMA) issued an important joint statement summarizing the developments of the U.S.-EU Financial Markets Regulatory Dialogue (FMRD). The statement harkens to the sentiments of strong cooperation and shared interests in continuing to implement and enforce robust, global standards, including those on the G-20 financial regulatory agenda.

From the above it is clear that it is widely recognized that bank regulatory policy changes need to be made consistently, and global leaders have agreed to the overarching aim with overwhelming support. However, the spirit and prioritization of global cooperation and coordination has decreased as policy makers grapple with political pressures, and legislative and legal processes, resulting in a fragmented approach and uncoordinated timeframes as global frameworks are implemented nationally. Hopefully, recent examples of cross-border dialogue can be a platform for change. Multiple, potentially inconsistent and localized layers of rules do not support growth or stability but rather create an overly complicated patch work of regulation.

Fragmented Rules Appear to be a Global Policymaking Trend

Notwithstanding the history of the G20 and FSB statements on harmonization, the record belies this intent, as exemplified though a recounting of key policy decisions which move towards the negative trend of fragmented and uncoordinated approaches taken by national regulators. These approaches are often super-equivalent and do not recognize, via equivalence or mutual recognition, the regimes of other regulators. Three specific case studies highlight the missed and potential opportunities on this front: capital and liquidity, CCPs, and TLAC.

Case Study 1 – Capital and Liquidity: Unharmonized Approach to Core Requirements

Basel III Capital and U.S. LCR

Capital requirements for globally active banks via Basel III have their complexities, especially given the national implementation of these rules, but this process is well underway. Calibration is nevertheless needed to ensure global consistency and work towards balancing stability and growth. In this respect the risk weighted asset (RWA) and leverage ratio requirements will continue to play an important role in defining a bank’s capacity to intermediate credit and provide services while safely meeting regulatory demands. The RWA and leverage requirements are also intertwined with, and are the entry point, for determining the proper level of minimum Total Loss Absorbing Capacity (TLAC) under the Financial Stability Board’s (FSBs) proposal. This FSB TLAC work (discussed in detail later in the article) provides a great opportunity for globally harmonized standards.

Regardless of the potential for harmonization on the capital front, there are examples where this type of success was not attained. A prime example is the U.S. version of the globally agreed upon Liquidity Coverage Ratio (LCR). To be clear, the U.S. agencies efforts to strengthen liquidity regulations and to reduce the potential risks to the financial system that can result from the inability of a supervised organization to meet its short-term liquidity needs are absolutely necessary and must be supported. Likewise, it is reasonable to conclude that these efforts are an essential component of the overall goal of improving the resiliency of financial institutions. However, FBOs are already subject to a stringent liquidity framework under home country regulations. Moreover, the U.S. approach to the LCR is ‘super-equivalent’ to the internationally agreed upon standard and, as discussed below, does not foster global cooperation or comparability of global banking organizations.

The U.S. approach to the LCR demonstrates how a single rule can disrupt both the alignment of global regulatory approaches and the establishment of harmonized global standards. It also obscures the comparison of the relative liquidity position of banking organizations in different jurisdictions. For example, there is a notable difference in the accelerated phase-in of the minimum LCR requirement for covered companies versus the global standard. This will be further complicated when the U.S. agencies issue an anticipated notice of proposed rulemaking (NPR) covering LCR requirements for Intermediate Holding Companies (IHCs). When that occurs, FBOs would have a global LCR plus a U.S. IHC LCR. This would equate to duplicative liquidity requirements emanating from the same core requirement. Similarly this logic applies to any of the other potential regulations that can be applied to IHC as an additional layer to the core global requirements that the present FBOs have to comply with.

Case Study 2 - CCPs: Uncoordinated Application of the G20 Commitment

In the U.S., the G20 commitment to CCP and derivatives regulation was largely implemented through the Dodd-Frank Act, and in the EU largely through the European Market Infrastructure Regulation (EMIR). Both sets of rules intended to ensure that as much of the over-the-counter derivatives market moved to central clearing as possible, the idea being that enhanced transparency and a more standardized market would bring stability and regulatory understanding to a complex market.

This in and of itself provided challenges resulting from nuances in national legislative processes, political climates and market players. Policy makers and regulators were forced to resolve a number of these ad hoc challenges through extraordinary action.

For example, in the margin requirements for uncleared derivatives, international consistency was ensured through the Working Group on Margin Requirements (WGMR) of the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) before national regulators finalized their respective rules in this area. The BCBS-IOSCO standards were finalized in September 2013, and both EU and the U.S. regulators have proposed rules to implement them.

However, while the national rulemakings broadly implement BCBS-IOSCO standards, there are some significant deviations from global standards which could reintroduce the prospect of regulatory divergence. The largest challenge that still remains in the derivatives space concerns recognition by one jurisdiction of another’s CCP regime. A key barrier has been a lack of mutual recognition between the EU and U.S. regimes, meaning that firms based in one jurisdiction would not be able to meet clearing mandates using CCPs based in another jurisdiction. This is problematic for perhaps the most global market, one where the two sides of the trade are very often based on the opposite sides of the Atlantic.

To date a large market disruption has only been avoided by rolling delays of the date upon which recognition requirements enter into force. This type of delay has led to significant market, investor and client uncertainty – none of these outcomes are aligned with safety and soundness and should not be allowed to permeate into other areas.

Case Study 3 - TLAC: An Opportunity for Harmonization

The current design of Total Loss Absorbing Capacity (TLAC) requirements, as contemplated in the recent FSB consultation paper, is a key example of a regulatory requirement that emanates from a globally objective and international agreement, but needs local level rules to implement. While the overarching objective is shared, there is a risk that fragmented, or siloed, approaches result in unnecessarily complex regimes – especially of concern to banks with home and host country regulators.

TLAC is currently at the stage where it can be the template for how global regulation can work for global firms, markets and regulators. A key question that needs careful consideration and global cooperation is deciding where in a global structure TLAC should be held. That is, it is important to ensure that TLAC is held in the right location of the group for the appropriate resolution strategy in line with an individual bank’s structure and operations. For centrally risk-managed, capitalized and funded banks, this should be single point of entry and TLAC held at group level.

To be fully effective, TLAC should be available to be down-streamed to subsidiaries in resolution. Existence of adequate intra-group arrangements to facilitate this, and regulatory criteria for allowing these to be used in a crisis, should be examined as part of resolution planning. Only if host authorities cannot agree with the resolution strategy and firm-specific cooperation agreement, which should address intra-group arrangements, should internal TLAC be required. This is consistent with the aim that internal TLAC would promote host authority agreement on group resolution plans. However, where agreement on resolution strategies and cooperation agreements is possible, internal TLAC is unnecessary and should not automatically be required. Additionally, the question around the manner of subordination of TLAC debt should be focused upon since it would potentially create distortions between banks with different structures (i.e. banks that already have non-operating holding companies versus those without).

Therefore, regulatory harmonization is extremely important for TLAC to be successful given its pivotal role in resolution and the need for global resolution regimes. TLAC is also at a policy development stage where a positive outcome can still be achieved. It seems reasonable that the optimal way to provide certainty, clarity and stability is through a globally agreed statutory regime, likely coordinated by the FSB.

Constructive Solutions Exist to Stem the Regulatory Trend

In order to advance the dialogue on how to address regulatory fragmentation, three main solutions are worth considering. First, policy makers must agree before the proposal process to ensure that the rules meet their intent by taking into consideration possible duplication and inconsistencies across jurisdictions. They must continue to operate with this in mind throughout the regulatory development. Second, regulators must focus less on super-equivalence versus core rules that are deemed globally sufficient. Third, there needs to be greater emphasis on regulatory equivalence.

Global agreement will lead to continuity and fit-for-purpose regulations

Global policy makers should not only focus on outcomes but also on how the outcomes are achieved. This would include striving to understand the impact of rules from the perspective of domestic firms, large FBOs, and universal banks that have to manage and apply rules on a multi-jurisdictional basis. This involves cooperation before, during and after the proposal process, essentially covering the full life-cycle of regulation. This process would further benefit from systemically implemented impact studies which the industry can help support to consider the multi-jurisdictional implications of the policy. It should also be complemented by more frequent and timely peer reviews and assessments. This holistic approach will be useful in justifying any divergence from the global norm and reducing the duplicative and conflicting provisions that might occur at the national level.

Core rules that are globally sufficient

The international standard must be ‘the standard’. Where there is G20 agreement on principles that are endorsed by the membership, national implementation should follow this charted course. This is not to ignore the reality that political forces, national policy-making processes or local requirements may vary by jurisdiction; however, the shared, stated objectives and global agreements should be closely aligned with the resulting rules.

If national implementation does not take into account the global dimension, then alternative, prescriptive approaches will result, as we have seen before, in fragmentation. Moreover, the use of super-equivalence to rules that are deemed globally sufficient (for example, in the U.S. Basel III and U.S. LCR and in the EU risk retention requirements and prudent valuation) do not help to advance any form of cooperation or consistency – they are by their nature intended to exceed what is deemed globally sufficient. While in some instances this may be necessary, it is not in every instance required and should not be the standard operating model for regulatory policy development.

The power of equivalence

Equivalence is the mechanism by which an authority in one jurisdiction considers the extent to which it can rely on another jurisdiction’s regulations. Equivalence can be considered via judgments, substituted compliance, and/or mutual recognition (bilateral or multilateral agreement). International bodies should be responsible for helping to advise on equivalence to develop a transparent, consistent and efficient framework. Giving international bodies more influence over equivalence decisions would also limit the extent to which accepting foreign regimes as equal becomes a politically charged discussion.

Equivalence has a number of benefits including consistency and convergence of practices, reducing duplicative requirements, and supporting the ability of financial institutions to meet client needs for access to funding, capital, risk, and liquidity management on a global basis.

For effective equivalence agreements, there are three broad categories to note – judgment, timing and adaptation. First, the process needs to take into account that judgment will need to be assessed against different standards globally versus locally. Second, timelines must take into account implementation status in other jurisdictions. Third, adaptation requirements to meet core local legal and market requirements may differ and need to be examined. Regardless of these considerations the benefits of this approach outweigh the negatives.

Conclusion

FBOs enjoy the privilege of operating in the U.S., and note that our participation in this market is beneficial for both FBOs and the U.S. financial system. FBOs also understand that participating in the U.S. market is accompanied by important regulatory obligations which have the distinct purpose of enhancing our safety and soundness; however, we believe that inconsistent and super-equivalent rules defeat this purpose. A level playing field makes the U.S. and the global financial system better. To achieve this important goal, international consistency and U.S. policy leadership are necessary. As a leader, U.S. policy makers should take a global view of the regulatory landscape to ensure that banks are safer, more comparable and resolvable while accounting for the fact that regulatory divergence in national implementation obstructs this goal.

That said, it should be noted that a significant amount of work has been done, and is being finalized, to ensure that no bank is too big to fail. This includes significantly enhanced prudential regulation (capital, liquidity and leverage rules) and increased capital buffers for the largest banks. Many of the specific policy recommendations and rules are proof that change is underway and resilience is growing; time is needed for these changes to be implemented and demonstrate their full benefits.

Consistency and a level playing field seem to be reasonable goals to achieve in the bank regulation policy sphere. In judging whether FBOs meet the required U.S. standards, the fact that FBOs are a part of a bigger group should be given credit. Without this, the current path will inevitably continue. Hopefully, future developments will take these concerns into account and will lead to an improved way forward.