Banks continue to try to game capital requirements

To see why requiring investment and commercial banks to have more equity is a risky way to prevent the next financial crisis, one need look no further than the April 13 Wall Street Journal story “Deutsche maneuvers around new law.”

From the story:

Hoping to sidestep new financial regulations that could have forced it to raise billions in new capital, Deutsche Bank AG is planning to restructure its U.S. operations, which would allow it to operate with a thinner capital cushion than the new rules envisioned.

Deutsche Bank AG is a German bank holding company.

Regulators require banks to use a certain amount of equity, or capital, in their operations, rather than debt, as a way to promote stability. At the time of the financial crisis of 2007-2008, all of the threatened commercial and investment banks appeared to have the correct levels of equity. That was because they had found ways to game their capital requirements, much as Deutsche proposes to do.

“This was the ‘new model’ of large complex financial institutions during 2003–2007 — to manufacture and take on systemic risk … but do so with little capital on the balance-sheet — which ultimately led to the financial crisis of 2007–2009,” write New York University economists Viral Acharya and co-authors in a 2010 study of the crisis.

Under Deutsche’s plan, its main U.S. subsidiary Taunus Corp. will stop being a bank holding company by moving its banking unit to the parent company, according to the Journal. Other units, such as the broker-dealer and investment bank, will stay where they are, and the bank will continue to operate as usual.

Barclays PLC has made a similar change, the Journal reported.

From the Journal:

The changes essentially allow the companies to avoid one of the goals of the Dodd-Frank law: to require foreign banks operating in the U.S. to hold thicker capital cushions to absorb losses in a crisis.

This took on new significance recently when the Supreme Court ordered the Federal Reserve to release the names of financial institutions that benefited from crisis lending and foreign banks topped the list.

Deutsche considered moving some of its business into a new Cayman Islands subsidiary to avoid the new capital requirements, the Journal reported, but it settled on eliminating the bank holding company structure instead.

From the Journal:

There is nothing improper about what the banks are doing. The Deutsche plan was presented to regulators at the Federal Reserve last year, said people familiar with the matter. A Fed spokesman had no immediate comment.

 The New York finance lawyer who blogs at Economics of Contempt, however, thinks the Deutsche Bank ploy will fail because even if Taunus isn’t a bank holding company, the Financial Stability Oversight Council will designate it as “sytemically important” and it will probably be required to meet the same equity standards as a bank holding company. From the blog:

To argue that Deutsche Bank’s US broker-dealer — one of the biggest, baddest dealers on the Street, and a major player in the derivatives markets — isn’t systemically important would be beyond ridiculous.