Friday, 21 September 2018

Devil in the detail

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  • German Chancellor Angela Merkel

A regulatory tug of war is being conducted in Germany. In the blue corner is the central bank, the Bundesbank, a grand old institution that has felt a little marginalised since its key functions were transferred to the ECB. In the red corner is the younger BaFin, the incumbent regulator that many have blamed for being asleep at the wheel when the financial crisis dawned. Justin Pugsley reports.

Ever since the Deutsche mark made way for the euro, the Bundesbank has, according to observers, felt a little redundant. It once set interest rates and preserved the stability of the mark. Monetary union saw those functions transferred to the European Central Bank.

However, the outcome of last year’s elections in Germany presented a splendid opportunity for the Bundesbank to address that void by orchestrating a coup to rearrange the country’s regulatory furniture in its favour. The election saw Angela Merkel’s Christian Democratic Union party able to dump their former coalition partners, the Christian Socialists Party, in favour of the smaller pro-market Liberal Democratic Party. This shift in Germany’s political dynamic gave the Bundesbank its chance to try to oust BaFin, which carries out supervision and regulatory enforcement in the financial sector. BaFin has been blamed for many of the regulatory failures during the financial crisis. Founded in 2002, it owes much to the Christian Socialists who were also its protector.

Numerous German banking associations have come out in favour of the Bundesbank being put in charge of regulation. There is a feeling among some experts that the Bundesbank employees can talk to bankers as an equal, seeing themselves as of similar ilk. That, they argue, would make them a better choice to supervise the sector. BaFin people, it is argued, see themselves primarily as regulators, and therefore lack the same affinity with the industry.

Other experts, however, believe the new coalition wants to create the illusion of addressing Germany’s regulatory failures by making high profile regulatory changes.

For the Liberals the motivation may be in part ideological: the party has been a staunch critic of BaFin for some time. An agreement to rearrange the regulatory furniture was set out in a treaty between the two political parties. “The coalition treaty between the CDU and the Liberals stated that they intend to concentrate banking supervision on the Bundesbank, while recognising that its independence is to be unaffected by its regulatory role,” said Grabriele Apfelbacher, a partner with legal firm Cleary Gottlieb, Steen & Hamilton. But there has been little detail about how that would work.

Banking on twin peaks

Though the Bundesbank appears to have the upper hand, putting the Bank at the apex of regulation is proving somewhat complicated. Axel Weber, the Bank’s highly respected and ambitious president, was promoting a unified banking supervisory model to be integrated into its existing organisational structure. BaFin would be relegated to carrying out the less glamorous roles of market supervision and consumer protection.

This twin peaks model, similar to French, Dutch and Italian practice, would produce complimentary benefits by dovetailing monetary policy with banking supervision, Weber said. This would create greater insight into the workings of the banking sector, would create efficiencies and enhance the capability of making the banking system safer. However, it would also have some awkward consequences. One in particular troubles politicians.

In the event of a bank failure, it would be an independent Bundesbank that would decide if it was to be bailed out, with German taxpayers picking up the tab. Clearly that is unacceptable to politicians. Purists would argue that central banks should stay away from regulatory enforcement: it is a politically fraught area that risks tainting their independence. Many feel that could eventually happen to the Bundesbank if it becomes the main regulator.

Contrast that with the current regime, in which BaFin plays a key role in bank rescues but is answerable to the Federal Ministry of Finance.

With the Bundesbank’s independence guaranteed by the Maastericht Treaty, this obstacle will be a tricky one to resolve.

An alternative structure put forward by some coalition politicians envisages a three-pronged holding organisation, integrating the Bundesbank, BaFin and SoFFin, the country’s financial stabilisation fund. “Under this agency the Bundesbank’s monetary functions would remain strictly independent,” said Apfelbacher. “But banking supervision would be subject to normal government oversight as it has consequences on fiscal policy in the case of bank failures.”

That structure may also address another concern: “The Bundesbank is worried about reputational issues relating to enforcement, particularly if one of its judgements ends up being challenged in the courts,” said one German regulatory expert. Though on the face of it this holding agency compromise might appear workable, if not somewhat complicated, there is no guarantee it will be implemented.

Again, the proposal might get beached on the details. In practice it could involve having a two tier board: some directors, namely those dealing with monetary issues, would remain independent, while others, including those working on regulation, were answerable to the Ministry of Finance. The Bundesbank is not thought to be keen on that.

Bundesbank’s detractors

The idea of the central bank becoming the lead regulator is not universally popular. Many critics, some of them regulatory experts, argue that the Bundesbank didn’t exactly cover itself in glory either during the financial crisis. The data BaFin uses to monitor the banking system is compiled by the Bundesbank, which, unlike BaFin, has offices across the country. Critics contend that it should have been flagging up issues with individual banks, such as when IKB ran into trouble. BaFin cannot properly defend itself because it is subordinate to the Ministry of Finance, others point out – a weakness they believe has been exploited by the Bundesbank’s PR machine.

BaFin itself argued it lacked the right legal instruments to do its job during the financial crisis. But there is a general consensus among experts that it was caught napping on the job when the crisis broke, so is at least partly responsible for the debacle that followed.

The Bundesbank’s wish to supervise insurers is also vociferously opposed by that industry. Insurers question the Bundesbank’s competence to supervise them, given that it is a bank, and warn that insurance requires different types of expertise. Combining banking and insurance regulatory methodologies would cause messy outcomes, they claim.

There are also potentially deep conflicts of interest. Insurers are major creditors to banks. What happens when one or more of them need rescuing? The insurers are afraid the Bundesbank would be biased towards banks and push for settlements that would unfairly disadvantage creditor insurance companies.

And there’s a further complication. Weber, an old style Bundesbank anti-deficit and anti-inflation hawk, is also a prime candidate to replace European Central Bank governor Jean Claude Trichet when his mandate ends on October 31, 2011. Should he be selected, the Bundesbank will have lost a very influential defender.

Others think the whole exercise is a waste of time, particularly when there are more pressing regulatory issues to focus on. The Bundesbank BaFin saga can be seen as a sideshow, diverting attention from the far more consequential debates involving Basel 3, the EU’s Capital Requirements Directive and the G20 agreements to make the financial system safer. On the other hand, the two seem to have found the time for crucial negotiations over the detail of proposals tabled by Basel, Brussels and Berlin.

Finding a compromise that satisfies the Bundesbank and the various political coalition partners could simply be a step too far in the short term. That would leave a whiff of uncertainty hovering over Germany’s regulatory set-up for a while longer.

“There’s not a lot of time to push the reforms through. They could agree to postpone this for a while,” said Angelo Lercara, a partner with legal firm Dechert. There appears to be too much political capital invested in the reforms for them to be dropped completely, however. They’re supposed to be enforced by April 2011 and there isn’t even a draft legislative paper on the table yet. Media speculation suggests there will be something on the matter from the second half of June, possibly tagged on to a bill covering the bank resolution regime.

Some experts reckon a better solution would be to concentrate on improving the expertise and competence of BaFin’s staff. Would the Bundesbank have done any better, had it been in the driving seat? “They need to improve the quality of staff, pay better wages and attract people from banks who really understand how they work,” said the anonymous regulatory expert.

The whole process has now become highly political, involving a large number of different players. The risk for the Bundesbank is that it could lose control of the debate and be lumbered with a solution that risks compromising its independence and integrity. It should be careful what it wishes for.  

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