Obama's Landmark Banking Law: US Leapfrogs Sluggish EU on Financial Reform

It's an old cliché, but it was proved to be true once again last Thursday: The United States takes action while Europe, and Germany in particular, does little more than talk.

With the votes of three renegade Republicans, the US Senate approved the roughly 2,400-page Dodd-Frank Act, named after Senator Christopher Dodd and Barney Frank, the head of the banking committee in the House of Representatives. The legislation is the Americans' response to the financial crisis that began in their country more than three years ago.

The law imposes tight constraints on financial institutions that trade in complex securities and engage in highly speculative transactions. Also, it greatly strengthens the role of bank regulators and the rights of consumers to protect their interests.

In passing the legislation, the United States is, once again, a step ahead of European nations. While German politicians are still debating whether the country should continue to support a tax on financial transactions or how a possible bank tax could be structured, the motherland of capitalism has "actually approved an enormous package," says a German government official.

In doing so, the Americans have established a benchmark. European banks that do business in the United States will now have to adhere to the standards Washington sets, which strongly limits the possibilities for European governments and the European Union to enact other rules.

Fear of Regional Differences in Banking Regulations

In theory, the governments in Berlin, Paris and Rome could determine what they want to happen within their own borders, provided their parliaments play along. But this would lead to a regulatory regionalism under which banks in the respective countries would suffer far more than the major US institutions. This is because European banks tend to be more dependent on their US business than US banks are dependent on business in Europe. After all, the US financial market is by far and away the world's largest.

This explains the German government's relatively muted reaction to the new US law. Not a single German politician whose name is even slightly recognizable was willing to comment on the bill by Friday.

A few politicians are criticizing the law, but only under the condition that they are not quoted. They say it is too complicated, too unclear and, most of all, that it leaves too many loopholes open.

Of course, the original version of the Dodd-Frank Act was clearer and less compromising, because the wording was significantly watered down during the parliamentary process.

Separating Commercial and Investment Banking

The beginnings of the new law can be traced back about six months to the so-called Volcker rule, named after Paul Volcker, a former chairman of the US Federal Reserve. Volcker, now an advisor to US President Barack Obama, had proposed a return to the separate banking system.

Under Volcker's proposal, commercial banks catering for private customers would have been barred from engaging in any speculative transactions, while investment banks would have been permitted to continue doing so. The advantage was that investment banks could no longer become too big to fail and, therefore, would not have to be bailed out with federal funds.

Although the new rules are not as simple and straightforward as Volcker's proposal, they are far from ineffective. Among other things, the law stipulates that when a bank is threatened by bankruptcy, the government can wind it down in an orderly fashion. This is so that taxpayer funds will no longer have to be used to rescue ailing banks.

The law also regulates the trade in highly speculative derivatives. In future, it will no longer be possible for two bankers to trade in derivatives by phone. Instead, they will have to do so on an exchange or through a clearing house.

In addition, the highly speculative business activities that banks have engaged in until now, with hedge funds, for example, will be strongly curtailed in the future. Proprietary trading will also be limited while regulators will see their rights increased substantially and their powers bundled.

Complex Lawmaking Procedures Hampering EU Response

So why haven't the Europeans managed to achieve anything similar? The answer is somewhat sobering.

When it comes to financial issues, the governments of the EU member states don't actually call the shots. In fact, the European Commission is the key lawmaker on financial matters. It has the so-called monopoly of initiative: Even if they wanted to, neither the parliament nor the Council of Ministers could propose legislation relevant to the domestic market. But Michel Barnier, who was named EU Commissioner for the Internal Market in February, has not proposed a single piece of draft legislation to date. And even if he had been hard at work, the 27-member EU's voting mechanisms are much too sluggish and slow, and are subject to too many different interests.

No European government has addressed this issue yet. The new rules applicable to lawmaking at the European level have only recently been enshrined in the Treaty of Lisbon. Thanks to a number of failed referendums, it took several tries before the treaty was finally ratified by all EU members. Amending the treaty would require an enormous feat of strength, which explains why the voting mechanisms are still so rigid.

For this reason, a European expert in the German parliament, the Bundestag, believes it is extremely likely that a law to regulate banks in Europe would end up being watered down even more than that in the United States.

From the very beginning, the Americans reacted far more consistently to the financial crisis. They forced their banks to accept government funds, and in doing so they helped create certainty on the financial markets.

The Europeans, for their part, have only now agreed to publish the results of a stress test for banks. At the same time, the criteria they stipulated were so lenient that the test can hardly be expected to reassure people.

And while the Americans are intervening in the business models of their financial firms, politicians in Brussels have spent the last few weeks arguing over what powers to give a planned European banking supervision authority.

Originally, the international community seemed determined to react in unison to the challenges of the financial crisis. Since then, stricter and stricter criteria have been called for at every G-20 summit, while concrete decisions have always been postponed until the next summit.

The world must "act in concert," German Finance Minister Wolfgang Schäuble wrote recently in the German financial newspaper Börsen-Zeitung. Schäuble argued that the federal government had a vital interest in actively participating in the development and implementation of international decisions to regulate financial markets.

This argument reflected the fear that German banks could suffer a competitive disadvantage if individual countries enacted their own financial regulations, which Schäuble wanted to avoid. But he didn't stand a chance.

Still, the situation where a country goes it alone can also have its benefits -- provided that country makes the right decisions and is strong enough that others must follow.