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Geithner Meeting Barnier on Basel III Presses Banks

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U.S. treasury secretary Timothy Geithner listens to a question during a news conference. Photographer: Andrew Harrer/Bloomberg
U.S. treasury secretary Timothy Geithner listens to a question during a news conference. Photographer: Andrew Harrer/Bloomberg

May 17 (Bloomberg) -- Two days after European Union leaders announced an almost $1 trillion plan to shore up debt markets, Michel Barnier, the EU’s financial services commissioner, was eating scones and sipping coffee with Timothy F. Geithner.

Also on the menu at the Washington meeting, Barnier’s first with the U.S. Treasury secretary: new international rules being considered by the Basel Committee on Banking Supervision. In a statement after the talks, the two men affirmed their commitment to push for “stronger capital and liquidity requirements.”

The May 12 meeting, one of a series Barnier held last week with U.S. bankers, regulators and government officials, signals the growing importance of politicians in setting global banking rules. The Basel committee is racing against a December deadline set by the Group of 20 nations, and banks faced with raising what UBS AG estimates may be $375 billion of fresh capital are appealing to nationalist sentiments to ease the pain.

“Governments have realized they need to be more involved in capital standards of their banks,” said V. Gerard Comizio, a former Treasury Department lawyer who is now a senior partner at Paul, Hastings, Janofsky & Walker LLP in Washington. “So the negotiation isn’t only among regulators now but is dragging in finance ministers and even heads of state.”

Driven by Politicians

The 36-year-old Basel committee, which sets international capital standards for banks, is rewriting those rules after the worst financial crisis in more than 70 years. An earlier revision, known as Basel II and initiated by lenders in the late 1990s during an era of deregulation, failed to prevent the collapse of European banks that adopted it. This time the process is driven by politicians, and bankers may have less influence, committee members and bank lobbyists say.

Negotiations over Basel II, which took six years to complete, lowered capital requirements by as much as 29 percent for some banks, according to a 2006 study by the Basel committee. The change represented a paradigm shift: Instead of relying on standardized formulas, Basel II let the largest banks use internal models to calculate the risks of their assets in determining the capital charges against them.

The current round of changes, informally known as Basel III, was spurred by G-20 leaders who urged the committee to improve the quantity and quality of bank capital, strengthen liquidity requirements and discourage excessive leverage.

The stakes are high. In addition to forcing banks to raise hundreds of billions of dollars, the rules could curtail lending, slow economic growth and eat into profits. JPMorgan Chase & Co. predicted in February that annual earnings at 13 of the largest banks would drop by $20 billion.

‘Different Animal’

While the new rules will continue to rely on banks’ risk models, they call for tighter control of what goes into those calculations, a narrower definition of what counts as capital and higher charges against holdings such as derivatives. The committee also may impose an as-yet-undetermined cap on the amount of assets a bank can have in relation to its equity.

“Basel III will be a very different animal,” said Charles Goodhart, a former Bank of England policy maker and professor at the London School of Economics. “We can say with conviction now that Basel II failed. It led to a relaxing of capital minimums. Regulators now understand the lessons and are trying to fix the problems.”

Banks are resisting, appealing to regulators and politicians in their home countries on the grounds that they would be disproportionately affected.

BNP, Deutsche Bank

Michel Pebereau, chairman of BNP Paribas SA, France’s largest bank, and Clemens Boersig, chairman of Deutsche Bank AG, Germany’s biggest, wrote to G-20 leaders last month on behalf of the European Financial Services Round Table, a lobbying group, saying the new rules would harm bank lending more than capital markets. “Most European countries mainly have a banking-dominated financial system,” they wrote, noting that credit outstanding as a percentage of gross domestic product is almost twice as high in the 27-nation EU as in the U.S.

U.S. banks have made opposite arguments in their meetings with regulators and in letters to the Basel committee: The rules will harm them more than European and Asian lenders. New definitions of capital wouldn’t count certain assets used only by U.S. banks, and the liquidity standards underrate the stability of deposits insured by the Federal Deposit Insurance Corp., the lenders said.

“A fair degree of national discretion will be essential,” the American Bankers Association wrote in April.

Liquidity Rules

Proposed liquidity rules, which would require banks to better match the maturities of their assets and liabilities, may cut European bank profits by 10 percent, Credit Suisse Group AG said in a May 10 report. The same rules will force U.S. lenders to raise $2 trillion through the sale of long-term debt, bank treasurers said at a meeting with regulators last month in Washington, according to three people who attended the session.

Deutsche Bank was among European lenders expressing concern that the U.S. might not adopt Basel III, as it didn’t implement Basel II, putting them at a disadvantage to American rivals.

“The United States continues to influence the Basel process but, in effect, treats the guidelines as optional,” Andrew Procter, the bank’s head of government and regulatory affairs, wrote to the committee. “Deutsche Bank believes that no other Basel committee members should move ahead with implementation until there is a clear timetable from the U.S.”

Obama administration officials say they’re committed to full implementation of Basel II by early 2011 and to working with the committee to devise stricter capital requirements. Basel III is scheduled to go into effect by the end of 2012.

Cross-Border Lobbying

While banks are pressing for more time before the rules are completed -- almost every letter they sent to the committee in April made such a plea -- Basel members say they expect agreement on the capital regulations by the end of the year as scheduled. Two said there may be a delay in reaching a consensus on liquidity requirements.

Some banks are looking across borders for allies in their attempts to water down or delay the new rules. The Securities Industry and Financial Markets Association, a U.S.-based trade group, has asked for meetings with Japanese, Brazilian, Chinese and Russian regulators to galvanize opposition, according to a person familiar with the group’s plans. Japanese, French and Canadian officials have argued that their banks didn’t suffer during the 2008 meltdown and don’t need to be punished.

‘Jury Still Out’

Regulators, central bankers and finance ministers from all G-20 countries sit on the Financial Stability Board set up last year to oversee the work of groups setting international standards. The FSB, which also includes representatives of organizations such as the International Monetary Fund, replaced the Financial Stability Forum, a think tank with no formal role that was created in 1999 after the Asian financial crisis.

The “jury is still out” on whether the G-20’s leadership will fix problems in financial regulation, said Pascal Lamy, head of the World Trade Organization.

“Will the G-20 really deliver as the ‘the premier forum for international economic cooperation?’” Lamy said in a speech in Manama, Bahrain, last night. It “has not yet, visibly, filled in the regulatory gap in international finance that was the main cause, if not ‘the’ cause, of the financial explosion.”

The FSB is the mechanism through which governments can exert pressure, members say. About half of the 64 organizations represented on the FSB also have seats on the Basel committee, which brings together delegates from 44 supervisory agencies in 26 countries and Hong Kong.

Basel Tower

The FSB is housed on the 11th floor of a round, 20-story glass tower in Basel, Switzerland, a city of 190,000 people better known for its international art fair and as the headquarters of drugmakers Novartis AG and Roche Holding AG. The executive offices of the Basel committee are one floor below.

The committee gathers four times a year around an oval table in Meeting Room D on the first floor of the building, according to one former participant. It doesn’t disclose the names of its members, publish minutes, or have a press officer. A request by Bloomberg News for a list of people attending meetings of the committee and more than a dozen subcommittees was turned down.

“I don’t think they’ve ever given those names,” said Lisa Weekes, a spokeswoman for the Bank for International Settlements, which is housed in the same tower and provides support staff. She said she didn’t know why.

‘Siamese Twins’

The committee is under pressure to finish negotiations by the end of December, a year after it published the first version of the new rules. The deadline was set by G-20 leaders in September.

Politicians on both sides of the Atlantic need to show constituents that they have addressed the underlying causes of the financial crisis, William Kennard, U.S. ambassador to the EU told European bankers last month. The EU and the U.S. need to collaborate on common rules, he said.

“There is a real imperative to get this right and to work in harmony,” Kennard said in a speech at the BNP Paribas Fortis auditorium in Brussels on April 26. “The notion that we could go in separate directions and both be successful just doesn’t exist. We’re kind of like Siamese twins.”

‘Political Pressure’

There’s enough of a consensus for reform in both the FSB and the Basel committee that national interests likely will be overcome, according to four members who belong to both groups. Issues that can’t be resolved will be settled by the G-20 leaders during a meeting in Seoul in November, they said.

“It’s good that there’s public and political pressure,” said Robert Pozen, chairman of Boston-based MFS Investment Management and author of the 2010 book “Too Big to Save.” “That will help new Basel rules become reality. It’s no longer possible, given what’s happened in the last few years, for the Basel process to be apolitical.”

A Basel accord is also important for the future of the G-20, said Barbara Ridpath, chief executive of the International Centre for Financial Regulation, a research organization in London funded by banks and the U.K. government.

“If the G-20 does not manage to get consensus on key financial-sector reforms in most major jurisdictions, it will lose authority,” she said.

Price Worth Paying

Nout Wellink, president of the Dutch central bank and chairman of the Basel committee, has said the planned reforms may lower global economic growth by as much as 1 percentage point. That’s a price worth paying for a stable financial system worldwide, he told the Financial Times on May 4. His comments to the newspaper were confirmed by his office.

National regulators are completing studies this month of the impact the proposed rules will have on their banks. The Basel committee’s Policy Development Group is scheduled to meet in June to evaluate the results. The full committee will take up the matter in July. Another round of studies, on the economic impact of the rules, will be done this year in coordination with the IMF and the FSB.

“There’s a balancing act that the politicians need to play, between making the system really safe and keeping it relevant,” said Mark Flannery, a finance professor at the University of Florida in Gainesville who has tracked Basel for two decades. “If you restrict the banks too much, financial activity will be curtailed or it will shift to non-banking institutions, making the rules irrelevant.”

Championed by Banks

The first Basel agreement came about more than two decades ago when the U.S. and U.K. encouraged other countries to adopt their new capital requirements, according to the 2008 book “Banking on Basel” by Daniel K. Tarullo, who became a Fed governor in January 2009. The rules were aimed at increasing the capital banks had to hold as a buffer against losses after the 1980s Latin American debt crisis, when some U.S. banks failed or were bailed out by the government.

The Basel committee, which had only 12 members at the time, took less than a year to hammer out an agreement. More than 100 nations adopted the rules.

Basel II, by contrast, was championed by banks, which argued that a more modern approach to risk management had emerged and needed to become the basis for capital regulation. The push was led by the largest U.S. banks and the Federal Reserve Bank of New York, headed at the time by William McDonough, chairman of the Basel committee during most of the negotiations and later vice chairman of Merrill Lynch & Co., according to four people involved in the talks.

The views of the lenders were incorporated into four drafts produced by the committee, according to the people. Political leaders weren’t involved in the talks, they said.

Four Years Later

After the rules were promulgated in 2004, U.S. community banks helped slow their implementation, the people said. They lobbied congressional lawmakers saying the new standards would give an unfair advantage to the largest banks because they were the only ones able to invest in the complicated risk-management systems on which Basel II was based.

Under pressure from Congress, which held hearings on the matter, the Fed and other regulators drew out the implementation of Basel II, setting up hurdles that needed to be cleared before banks would be allowed to reduce their capital. The largest U.S. banks are on schedule to complete the process by the first quarter of 2011, four years after many European countries put the rules into effect, regulators say.

Internal Risk Models

Goldman Sachs Group Inc., Morgan Stanley, Lehman Brothers Holdings Inc., Bear Stearns Cos. and Merrill Lynch were allowed in 2005 by their regulator, the U.S. Securities and Exchange Commission, to base their capital needs on internal risk models, which led to an increase in leverage levels over two years to 31 times equity on average from 24 before the rule change. Lehman filed for bankruptcy in 2008, while Merrill and Bear Stearns were forced into shotgun marriages with bigger rivals.

“If we had implemented Basel II, we’d be in more trouble,” said Hal Scott, a Harvard Law School professor who specializes in international finance. “One pocket of our financial system did adopt Basel II, the biggest investment banks. Look at what happened to them.”

The financial crisis was a result of banks taking advantage of different rules on the two sides of the Atlantic, said Goodhart, the London School of Economics professor.

European lenders could buy as many AAA-rated mortgage bonds as they wanted, since they had no leverage caps and their Basel II models treated the securities as almost riskless, he said. U.S. commercial banks, which had leverage limits, kept the riskiest and smallest tranches of the same securities because they didn’t have to post additional capital that Basel II would have required.

Geithner’s Role

Basel III is an attempt to rectify that problem by changing the way banks calculate such risk, proponents say. It also would create a buffer above the minimum capital requirement and force banks to cut dividends if their capital falls below that level as a way of keeping them from lowering capital in good times.

Because the new rules are technical in nature, politicians aren’t involved in the day-to-day debates, members of the Basel committee and its subcommittees said. They will have a say on issues where regulators from different countries can’t resolve their differences, they said.

Geithner, 48, is expected to get more involved after Congress passes financial reform legislation, according to a European official who has discussed the issue with him.

Trump Card

Barnier, 59, who was in charge of the 1992 Olympic Winter Games in Albertville, France, is already working “hand in hand” with the Basel committee to translate its rules into EU directives, he said last month.

There are still many questions to resolve: how derivatives contracts are netted when they’re calculated in total assets; whether the leverage caps will be binding; how liquid assets are defined; if there should be a supranational regulator. The leverage requirement, favored by European and U.S. politicians and included in two G-20 statements last year, is opposed by some EU regulators, reflecting the largest European banks’ concern that they will have to shrink more than U.S. counterparts under the rule.

In addition to playing those differences, the banks have another trump card they’ll likely use: FSB chairman Mario Draghi. The Italian central banker, a former Goldman Sachs vice chairman, has been more sympathetic to the banks’ views than most other members, lobbyists say.

Lawyers, Accountants

The FSB’s top priority this year is to complete the reform of Basel rules, Draghi said at a news conference last month.

“We should not dilute the long-term objectives of the reform, but be open to appropriate transition times not to hurt our banks and our economies,” he said.

Even when new Basel rules get implemented, lenders may find ways around the rules, said Joseph Mason, a professor of finance at Louisiana State University in Baton Rouge.

“Wall Street will always have more lawyers and more accountants and more brains than the regulators,” Mason said. “They’ll always innovate, come up with new things to arbitrage the rules. It’s not really the rules, but how regulators look at the full picture and see problems before they develop. That’s far from certain going forward, regardless of what Basel III achieves in fixing past problems.”

To contact the reporters on this story: Yalman Onaran in New York at yonaran@bloomberg.net; Simon Clark in London at sclark4@bloomberg.net; Joseph Heaven in Zurich at jheaven1@bloomberg.net.

To contact the editors responsible for this story: Edward Evans at eevans3@bloomberg.net; Alec McCabe at amccabe@bloomberg.net; Anthony Aarons at aaarons@bloomberg.net.

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