Source: Flickr / Noah Reynolds.
The Fed's new rules for large foreign banks strengthen capital and liquidity requirements, making it so that operating on American soil means playing by American rules. Some have argued that this move will reduce profitability in the financial sector, but to me, that's not the part we should be worrying about.
Reduced profits are one thing. But how will banks respond to that?
Balkanization theory
The idea is that the "Balkanization" resulting from such rules will reduce profits for banks by tying capital down and increasing borrowing costs, reducing efficiency.
Because of the way they operate, Deutsche Bank (DB 2.07%) and Barclays (BCS 1.82%) both have quite a lot of ground to cover in meeting the new Fed rules. Both firms changed their structures after Dodd-Frank to avoid regulation, and Deutsche Bank has been notable for operating with negative capitalization in the U.S. Barclays, for its part, has even more threats to its profitability -- with new rules in the UK, it's getting a double-whammy of new regulation and capital requirements.
Incentives to double down on risky strategies
Having an inefficiently strong capital base isn't a bad thing in this day and age. We're not the era of simple borrowing and lending; banks are now global institutions involved in a range of activities. Additional capital buffers seem like the bare minimum in establishing some level of stability.
However, rules that result in lost profitability for some (rather than all) could lead some banks to pursue riskier strategies in order to keep up with the Joneses. This to me is a big concern.
BCS Pre-Tax Income (Quarterly) data by YCharts
Barclays and Deutsche Bank had, by many measures, a pretty bad year, and both are facing another tough one with the forex and gold fix scandals. If I were the leadership of one of these banks, I could accept that my margins are simply going to change and focus on improving the internal compliance and stability of my bank. Alternately, I could green light regulatory arbitrage measures and riskier trading strategies to try to try to juice my returns.
I would love it if all banks pursued the former; I regret that I'm inclined to believe that the latter is more likely.
Added risk from bickering regulators
Even worse, other regulators are complaining about the Fed's go-it-alone strategy and have, by some readings, threatened retaliation. What would happen if European regulators decide to "level the playing field" in turn for the benefit of their local banks?
On the surface, this sounds sort of like a bubble-blowing arms race: kind of nice. On the other hand, if it becomes less about equalizing rules to ensure the stability of the financial system and more about protecting the profitability of local banks, it could divert quite far off the point.
Combined with any attempts to enhance profitability through risk seeking, the result is unlikely to be a harmonized and stable global financial system we were all initially hoping for.
