The Long Arm of the Volcker Rule

The new Volcker Rule seeks to prevent banks that are ‘too big to fail’ from trading on their own account. The idea is that institutions that benefit from public guarantees like deposit insurance and the central banks’ lender of last resort function shouldn’t be allowed to make risky bets that will fall to the taxpayer if they turn sour. This principal served the US well for decades under Glass-Steagall, which separated many commercial and investment banking functions. But despite the Volcker Rule’s good intentions, one unforeseen consequence threatens to disrupt global financial stability and poison relations between US and foreign banking regulators.  

European (and Canadian and Asian) banks, finance ministers, and regulators have all recently criticized the Volcker Rule because of its ‘extraterritorial’ provisions. This obscure bit of legal jargon refers to the fact that the long arm of US regulators threatens to reach across the Atlantic and impose domestic US rules on European financial institutions and markets.  


The Europeans are particularly concerned about the proposed rule’s exemption of US Treasury bonds, but no other sovereign bonds, from its restrictions on proprietary trading. As currently written, any bank with operations in the US, whether it is headquartered in the US or not, could trade US Treasuries but could not purchase European sovereign debt unless it was on behalf of their clients. Not only would this drain liquidity from Europe’s sovereign debt markets, but European banks (who must trade in European sovereign debt as a matter of course) with US subsidiaries might be forced to divest their US operations. As Europe is still trying to solve its sovereign debt crisis, a rule that seeks to make ‘too big to fail’ US banks safer could end up destabilizing the Eurozone at a particularly vulnerable moment.  

US regulators, however, are bound by the Dodd-Frank Act to ensure that broadening the exemption to include sovereign or other types of debt would not impact US financial stability or the soundness of its banks. It could be hard to argue that allowing US banks to invest in, say, Italian or Greek sovereign bonds, is a safe bet. 

Part of the problem here is that the US and Europe have very different financial sectors. Continental Europe has long been home to big ‘universal’ banks that combine commercial and investment banking functions. These banks tend to be much more highly levered than their US counterparts, and dominate commercial lending to a much greater extent than in the US, where corporate bond markets are more developed. So rules that make sense on one side of the pond get lost in translation when applied to fundamentally different financial sectors. Just as every unhappy family is unhappy in its own way, unsound financial sectors have their own unique problems.  

Nor is it just the Americans that are flexing their regulatory muscles. The EU has floated many new regulations that could affect US financial institutions. Proposed EU rules on derivatives, clearinghouses, hedge funds and ratings agencies could prevent US firms from operating in these areas unless EU regulators deem US rules ‘equivalent’ to those in the EU. The precise definition of ‘equivalent’ remains as yet undefined, but the risk is that well-intentioned misunderstandings among regulators could transmogrify into outright financial protectionism. 

It is worth remembering that prior to the financial crisis, it was regulatory arbitrage – that saw financial institutions taking advantage of lax or uncoordinated regulatory regimes – rather than extraterritoriality that was a big problem. For example, Icelandic banks were allowed to operate in the UK and the Netherlands without UK or Dutch oversight under the assumption that the Icelandic banking authorities were doing the job of regulating their own banks. As such, the Icelandic authorities bore fiscal responsibility for the deposit insurance schemes of Icelandic banks operating abroad. Unfortunately, Icelandic banks were allowed to grow their balance sheets to such an extent that they were 12 times larger than Iceland’s GDP. So when these banks went bust, Iceland simply did not have enough money to guarantee foreign depositors’ savings accounts. Instead, British and Dutch taxpayers had to pay up.  

By the same token, the interconnectedness of global finance has allowed contagion to spread across the globe, even as investors depended on foreign regulators to do their due diligence – which they too often failed to perform. Because of lax US regulation of its mortgage market, many European banks suffered large losses from their investments in US mortgage backed securities. Likewise, the bursting of the Irish and Spanish housing bubbles, and the collapse of many of these countries’ banks, hurt investors in the UK, France and Germany and spread contagion across the continent. 

It is thus no wonder that many are wary of depending on foreign regulators to safeguard the stability of domestic financial firms that have extensive operations abroad. Nobody wants their taxpayers to take the hit because some far off regulator wasn’t doing their job. And yet given the reality of global capital markets, increased international cooperation is precisely what the world needs more of now.  Regulators in one country need to take into account the effect of their rules on financial markets in other countries. 

We should, however, be careful of making too much of these regulatory conflicts. In many ways, the response to the global financial crisis has seen unprecedented international coordination. The Fed, the ECB, and many other central banks agreed very large bilateral swap arrangements to ease funding pressures both in 2008 and again last year when the Euro crisis hit. Several European banks were given access to the Fed’s discount window after the money markets seized up following Lehman Brothers’ collapse. And the Eurozone could yet move towards much tighter fiscal integration as the panic phase of the crisis recedes.

Indeed, the first thing that needs to be done when a financial crisis hits is stop it. By flooding markets with liquidity, first the Federal Reserve and more recently the European Central Bank have succeeded in halting bank runs and panic driven selling. But getting the patient out of the emergency room is just the first step in a longer recovery.  It is only once the initial panic is over that attention can turn to making the financial system healthier and safer.

Rehabilitation requires identifying a course of treatment that will cure the disease. But the US and Europe do not share the same illness. In the US, the crisis took the form of a run in the wholesale money markets. In Europe, flaws in the institutional design of monetary union are to blame.

The US and the EU are the world’s two largest economies, with the world’s most advanced financial systems. Rather than sniping at one another, policy makers and regulators in the US and Europe need to make sure they are on the same page. Whether we’re talking about regulatory arbitrage or extraterritoriality, stable and efficient financial markets depend on clear rules, professional oversight and good governance to operate effectively.  It should be possible for the US, the EU, and other countries with advanced financial systems to design regulations that encourage competition and innovation, ensure financial stability, and respect differences in local financial institutions.

Ben Carliner is a fellow at the Economic Strategy Institute. Prior to joining ESI, Mr. Carliner worked as a financial journalist in New York for Project Finance International. The original article can be found on Ben Carliner’s blog.

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