Banking regulators fail us again

Banking regulatorsCapital is a fancy term for the shock absorber that protects a bank from unexpected losses. It’s money or money-like; the more of it that a bank has, the better the chance that it can survive tough times without the help of taxpayers. But because capital is difficult and costly for a bank to raise, it never, ever wants to be told that it must raise more of it.

Only a fool or someone who has been asleep for the past few years would expect a bank to voluntarily to do the things that it ought to. This would be like expecting an 11-year old to start saving his pocket money for retirement. Nice idea, very sensible…not bloody likely.

On the other hand, of the parents who are in charge of raising the 11-year old, we should reasonably expect a bit more. And of the folks in charge of supervising the banks, we should expect the world given how badly they f–ed up the last time. So I don’t get the collective shrug that greeted the news that the largest-American-bank-that-you’ve-never-heard-of has figured out how to get around the new capital standards of the Dodd-Frank regulations.

Deutsche Bank is the biggest bank in Europe. Its American subsidiary, Taunus, is the 8th-largest bank in the US; it has $354 billion in assets. Before February 1, Taunus was considered to be a “bank holding company” because it was a legal entity that owned a bank (among other things).

The Federal Reserve usually requires these BHCs to hold a certain level of capital. But starting in 2001 it allowed some foreign-owned BHCs to ignore this rule. The Fed didn’t want to be difficult; it figured that these foreign banks were probably subject to pretty strict rules in their home countries and that, if these rules were good enough for those countries, then they were probably good enough for us. Plus if something did go wrong and the BHC needed more capital then, like a young adult that goes backpacking in a foreign country, it could just have its parents wire the money.

But after the banks helped to cause the worst crisis since the Great Depression, a new rule was added to Dodd-Frank to put a stop to this. Starting in 2015, all BHCs will have to meet a new capital requirement. For Taunus, this would have meant getting a new check of $20 billion dollars from Deutsche Bank.

When their hysterical laughter finally subsided, when they had stopped rolling around on the Oriental rugs, clutching their sides, and when the silken handkerchiefs had wiped away the last trace of their merry tears, the co-CEOs of Deutsche Bank called up the accountants and the paper pushers and said, “Get to work.” A few forms were filed and presto! Taunus is no longer a bank holding company.

To be specific, the entity that put the “bank” in BHC was moved out from under Taunus and put somewhere else. But Taunus will continue to be the parent of over 100 different other entities, including Deutsche’s US investment bank. In fact, the migrated bank was probably the safest business in Taunus. All of the riskiest activities — derivatives, structured finance, real estate finance, foreign securities trading, etc — are still in Taunus. And instead of approving Deustche Bank’s BHC magician’s trick, (for Matt Levine of Dealbreaker tells us that Deutsche “got to do it without much of a squeak from the Fed, which probably had at least some ability to step in and cause trouble if it wanted”)the Fed should have jumped at the opportunity given to it by Dodd-Frank to correct its own laxity and get more capital pumped into Taunus. Because not too long ago Taunus, due to the risky businesses that it continues to hold, was considered by regulators to be the ugly swamp creature of which nightmares are made.

Sheila Bair used to head the FDIC and in 201o she wrote a letter to a banking lobby group that had been whining about new capital rules. From the Wall Street Journal with my emphasis:

To defend her case Ms. Bair noted that the consolidated U.S. operations of an unnamed foreign bank have “negative Tier 1 capital.” In other words, after regulatory adjustments, these banking operations have an actual capital deficit. Ms. Bair may have been talking about Deutsche, whose U.S. bank holding company, Taunus Corp., has a Tier 1 risk-based capital ratio of negative 7.58%, according to a regulatory filing. With $364 billion of assets and a large derivatives business, Taunus isn’t a bit player. 

To be honest, the only reason that I can think of for the regulators not having stepped in already is…actually, I can’t think of a reason for the regulators not having stepped in. Here’s what Simon Johnson, MIT professor and former Chief Economist of the IMF told the Senate Banking  Subcommittee on Financial Institutions and Consumer Affairs last December:

Senator, I would commend [sic] your attention Taunus Corporation, which is the eighth or ninth largest bank holding corporation in the United States.  It’s a wholly owned subsidiary of Deutsche Bank.  It’s 77 to 1 times leveraged.  Deutsche Bank itself is a very highly leveraged global corporation.  Published news reports say that US regulators asked for additional capital to be put into Taunus because they regard the leverage as excessive in today’s environment because of the situation in Europe.  It hasn’t happened.  And I think the problem is exactly what you just put your finger on: we are no less vulnerable – perhaps more vulnerable now – to this incredible disaster in and around the banking system in Europe.  It is going to spillover to us in many ways – through counterparty risk in derivatives, for example.  But Taunus Corporation is a spectacular, in-our-faces demonstration of these risks becoming bigger, not getting smaller. 

Maybe what has happened is this: the regulators have fallen for the argument that the foreign parent entity will send money to the US daughter, but only when there’s a real emergency and not before. But this doesn’t always work as planned. This reminds me of IceSave, the Icelandic savings bank that went under in 2008, but not before it had taken several hundred billion euros in deposits from British and Dutch savers. The rules said that Iceland’s government should give the foreigners their money back. But when push came to shove, it didn’t. Instead, the British government and the Dutch government had to step in to prevent their citizens from losing their shirts. Iceland is supposed to reimburse them for this. It’s more than three years later and they’re still waiting.

Again, Deutsche is Europe’s biggest bank and Europe is in trouble. It doesn’t really matter how many fake stress tests it passes; there’s really no way to guess at just how exposed Deutsche would be if things got worse — both via its own direct investments, but also via its dealings with all other European governments, banks, companies and consumers who are exposed, themselves. If things go wrong then not only could Taunus could end up being the perfect channel to transmit Europe’s problems to America’s financial system (see Simon Johnson, again), Deutsche might be in dire straits, itself.
And if Taunus’ interconnection is such that its failure would threaten the American financial system, then you can bet that the American authorities will step in to save it. Would this result in another starring role for everyone’s favorite sucker, the US taxpayer?   Remember: when the Fed and the Treasury used extraordinary measures to save AIG, they really did it in order to save the banks to whom AIG owed money. Which included Deutsche Bank, to which AIG sent $5.4 billion of its rescue funds.
Given this history, why on earth did regulators sit idly by and allow Deutsche Bank — and UK bank Barclays — to skirt the new capital rules? You can reasonably expect that someone who’s in jail might, at some point, attempt to escape. But when is it ever acceptable for the prison guard to help him?