Is Reform Possible?: Europe and America Wrestle over Tighter Financial Regulation

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Finance Minister Wolfgang Schäuble was already working out the details of the concept when he received a call last Tuesday from his fellow cabinet member, Minister of Economics Rainer Brüderle. Of course, the people who caused the financial crisis would have to be held financially accountable, Brüderle told Schäuble. But, he added, the proposed tax would also affect institutions that had nothing to do with the financial crisis, such as savings banks and credit unions. For this reason, Brüderle said, his party, the FDP, could not support the plan.

Now the coalition faces difficult alternatives. Either it creates exceptions and special rules to ensure that only a few banks are required to pay the tax, or it drops the plan altogether.

Governments in many parts of the world now face the same dilemma. If they try to negotiate banking reforms to achieve a consensus among all involved, they lose too much time. But if they push ahead too quickly, they could trigger incalculable conflicts.

The European Union is up against the same problem, as it attempts to impose stricter rules on trading in all forms of derivatives. Until now, practically anyone could design and trade in such extremely complex financial products. Now the EU Commission has launched a first attempt to supervise the confusing field of hedge funds, private equity firms, commodity and real estate funds.

'Spiral of Protectionism'

If that happens, say lobbyists, capital will leave Europe's shores by the billions. This, in turn, would lead to mass unemployment and a "spiral of protectionism."

The British government has used similar arguments. This isn't surprising, as it feels the need to protect the City of London, the only remaining profitable and promising sector in the United Kingdom. About 80 percent of all European hedge fund assets are managed in London. For this reason, Britain's negotiators, often with the friendly support of their counterparts in Sweden and Finland, have gradually watered down the directives during negotiations in recent months.

Pressure has also come from the United States. Following in the footsteps of the banking industry, US Treasury Secretary Timothy Geithner wrote a letter of protest to European Internal Market Commissioner Michel Barnier at the beginning of the month. According to Geithner, the planned rules would make it more difficult for US investment funds and banks to do business.

German Finance Minister Schäuble disagrees. "Funds and managers from third countries will still have access to the European market," he says. "There is no discrimination taking place here. Instead, we are making sure that the same rules apply to everyone."

It will not be an easy decision for the senior members of the European Commission to make. If Europe insists on implementing the controversial guideline, a new major conflict could erupt with Washington.

Trading through a Clearinghouse

This helps to explain why many officials in Brussels were on edge last week, when they learned of the new German-French-Luxembourgian initiative to gain control over the CDS market. The plan would only create new friction with Great Britain and the United States, they complained, but would hardly offer more protection for the financial markets.

Deutsche Bank, the world's fourth-largest CDS trader, provided them with fuel for their arguments. "Regulatory intervention should be carefully considered and cautiously applied," a new study by the industry leader concludes. In particular, the bank study argues, it will be important to avoid "stifling the market with excessive measures."

The established CDS industry in London and New York also senses obstacles to competition. To improve supervision of the industry in the future, Merkel and her allies want CDS transactions to be conducted through a clearinghouse in the future, which would notify regulators if necessary.

The EU already has its eye on a suitable candidate. The lobbyists of Deutsche Börse AG, which operates the Frankfurt Stock Exchange, are now trying to offer their clearinghouse, Eurex Credit Clear, to the financial world -- but with little success to date. While the European branch of US competitor Intercontinental Exchange settled contracts for more than €1.4 trillion in the last eight months, the business in Frankfurt only runs into the hundreds of millions.

Handsome Profits

A substantial amount of resistance to the EU plans is taking shape in the United States, leading experts to doubt whether the bold CDS initiative will succeed. Some in banking circles say that the announcement may have been more important to the politicians than the issue itself.

Not surprisingly, the financial industry has not felt overly threatened by the industrialized nations' regulatory offensive. The financial crisis was overcome with the help of government bailouts worth hundreds of billions of euros, and many banks are already back to making handsome profits.

Morgan Stanley, for example, ended its 2009 fiscal year with $900 million in losses. In the same year, however, it distributed more than $14 billion in compensation to its employees, much of which consisted of controversial bonus payments to investment bankers.

The European and US banking giants spent a total of $275 billion to compensate their employees -- a 10-percent increase over the previous year.

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• Part 1: Europe and America Wrestle over Tighter Financial Regulation
• Part 2: The Impending Conflict with Washington