Photo Gallery: The Windy Path to Financial Reform

Foto: epa belga/ picture-alliance/ dpa

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

In the wake of the financial crisis, governments in Europe and the US sought to rein in the global banking sector. One year later, little has been accomplished -- and success in the near future seems doubtful. Competing oversight visions could increase trans-Atlantic tensions.
Von Beat Balzli, Wolfgang Reuter, Michael Sauga und Hans-Jürgen Schlamp

German Chancellor Angela Merkel isn't one for using aggressive language. Normally at least. But when it comes to the international financial industry these days -- particularly the dealings of investment banks, hedge funds and currency speculators -- she doesn't shy away from a bit of bellicosity. Words like "excesses" and "abyss" have become standard fare in her comments on the economy.

The chancellor, it would seem, is in combat mode. "The banks are trying to strike back, once again," she complains. Last Wednesday, Merkel decided to go on the offensive herself.

In a letter that was also signed by three of her European counterparts-- French President Nicolas Sarkozy, Luxembourg Prime Minister Jean-Claude Juncker and Greek Prime Minister Georgios Papandreou -- Merkel proposed a Europe-wide approach against so-called Credit Default Swaps (CDS), the highly complex form of credit default insurance that is believed to have been partly responsible for triggering and exacerbating the financial crisis, as well as fueling recent speculation over a Greek national bankruptcy. In the future, the letter reads, such financial products should be examined carefully, monitored more effectively and, if necessary, even partially banned. To put a stop to speculators, "Europe must assume a leading role."

While European governments were still hopelessly divided over the consequences of a looming Greek national bankruptcy, Merkel seemed determined to put a stop to the unbridled activities of the financial industry. Only a week ago, the US magazine Newsweek mocked the German chancellor, calling her "slow-motion Merkel."  Her latest move was intended to show the world a different sort of chancellor: a crisis manager.

Thirty-Six Regulatory Initiatives

It was a highly symbolic performance. At a meeting in London just 12 months ago, the leaders of the world's 20 leading industrialized nations insisted that they intended to monitor the banking sector more effectively in the future, as well as to ensure that "the financial crisis will never happen again." To date, however, hardly any actions have followed. Governments have established many international panels of experts, held conferences and produced position papers. The German government alone is involved in 36 international regulatory initiatives.

But nothing concrete has emerged from these efforts. On the contrary, many governments, irritated by the tedious global negotiation process, have launched national initiatives, the real purpose of which seems to be to give a leg up to their own banking industries.

Deutsche Bank CEO Josef Ackermann refers to these initiatives as a "patchwork" of contradictory regulations. And the president of the European Central Bank, Jean-Claude Trichet, warns that there are apparently some financial executives "who believe that things will continue as they have been."

Trichet's suspicion is well founded. No matter what national reformers have tried in recent months to tame speculators, they have consistently encountered resistance from what is probably the world's most financially powerful and hard-hitting lobby.

US President Barack Obama, for example, called his country's bankers "a bunch of fat cats" last fall, and then demonstratively backed the radical reform proposals of his crisis advisor, former US Federal Reserve Chairman Paul Volcker.

Next to Nothing

Among other things, the Volcker proposal would have barred banks from using private customer deposits to engage in speculative trading aimed at padding their earnings. Volcker hoped this would ensure that the failure of a financial services firm like Lehman Brothers could no longer shake the global financial system. It was a smart plan, but within a few weeks it was clear that its chances were next to nothing.

The resistance from major Wall Street institutions reached into the highest echelons of Obama's own party, taking a ban on speculative trading off the table. Now, the US president can count himself lucky if the controversial speculative transactions are subjected to slightly more scrutiny in the future than they have been in the past. "The question now seems to be whether we'll get a watered-down bill or no bill at all," writes US economist Paul Krugman. "And I hate to say this, but the second option is starting to look preferable."

Obama's European comrade-in-arms Merkel is hardly faring any better. In its coalition agreement, her government pledged to quickly push for regulation of the banking sector. In practice, however, the coalition of Merkel's conservatives and the pro-business Free Democratic Party (FDP) is making little headway. Many legal aspects of financial reform are proving to be so complicated that even experienced Finance Ministry officials are at a loss.

The planned amendment of the bank insolvency law, for example, was intended to ensure that lenders could fail in the future without posing a threat to the entire economy. To achieve this, however, claims against banks would have to be guaranteed by the government, at least up to a certain amount.

But this is difficult, if not impossible. Finance Ministry officials believe that if Citigroup failed, for example, it would disintegrate into more than 2,500 legal entities. All of these units would have to be placed under trusteeship, within hours if necessary, and their transactions would have to be frozen.

Five Years for Reform

This is one of the reasons officials in Berlin are putting together legislation that would enable the government to break up banks when they become too big. "This is where a wide range of different laws, constitutional principles and court decisions intertwine," complains a lawyer who is involved in the issue. "I have never seen anything as complicated as this." For this reason, he adds, it would take at least three or, more likely, five years to implement a financial reform proposal.

It has been a year and a half since investment bank Lehman Brothers failed. Since then, the chancellor has argued -- unsuccessfully, to date -- that the banks should assume a financial "share of the burden for the crisis." Much has been discussed, but no laws have emerged from the discussions.

On one occasion, Merkel said it was a "charming idea" to impose a special fee on bankers' bonuses, based on the British model. Then she championed a general tax on all financial transactions, from stock purchases to foreign-currency trading.

But the proposals were never meant to be taken entirely seriously. The government soon made it clear that a tax on bonuses would be incompatible with Germany's constitution, and that a transaction fee could only be introduced as a coordinated international effort, which, under the current circumstances, means never.

Now the government is pursuing the idea of requiring banks to pay a general fee. A tax on the balance-sheet total, which would generate revenues in the single-digit billions, is under discussion. The money would be paid into a fund that could be used to guarantee citizens' savings in the event of a crisis.

The Impending Conflict with Washington

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.

Translated from the German by Christopher Sultan
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