Eurocrats in Brussels enjoy the thought that Germany could face fines of Ecu250,000 ($287,500) a day for failing to implement the EU’s investment services directive (ISD) and the capital adequacy directive (CAD).
They regard it as “disgraceful” that such a key member of the single European market is two years late, and they want some revenge. Enforcing these two directives designed to harmonize standards of investment services, risk management and soundness of financial institutions across the EU is hard enough without one recalcitrant member adding to the disharmony.
The situation adds little to Germany’s reputation as a financial centre, and will keep the playing field decidedly unlevel for at least the next 18 months. German banks have the advantage of noncompliance with the CAD’s crude and expensive market risk requirements. German securities firms continue to be unregulated except at a rudimentary provincial level. One German banker’s advice to indignant foreign competitors: “Relocate here and enjoy the advantages while you can.”
Most EU countries have implemented the two directives, which were supposed to come into force in January 1996. Germany is the only country to have delayed on both. And it hasn’t yet responded to a “reasoned opinion” sent by the European Commission (EC) in February.
If it doesn’t reply within 60 days it can be taken to the European Court of Justice in Luxembourg. But given the grindingly slow process of warning letters and court hearings the eurocrats know the fining will never start.
Germany has taken its time, but finance ministry officials now say that the new banking law (KWG-Novelle 6), which will allow compliance with the ISD and the CAD, will get through its readings in parliament in July and come into force by August 1. That means that banks will start complying with the CAD at best by mid-1998.
The German excuse for the delay is that the complexity of its financial sector required changes to the law and even to supervisory philosophy. The delay is due not to unwillingness but to the sheer volume of work which hit a bottleneck in the understaffed departments of the ministry of finance’s seventh division and the Grundsatzabteilung of the Bundesaufsichtsamt für das Kreditwesen (BAKred), the banking supervisory office in Berlin.
The BAKred went as far as it could last year without changes to the law. From January banks in Germany have had to comply with “minimum requirements” meeting standards of control and information management, for example being able to check that their trading has been done at market prices.
The KWG-Novelle deals mostly with investment services. Prudential supervision of securities firms will be carried out by the already overworked BAKred, while their conduct-of-business will be supervised by the securities watchdog, the Bundesaufsichtsamt für den Wertpapierhandel (BAWe) in Frankfurt. In a few instances the new law goes beyond the requirements of the two directives. For example, German supervisors will have oversight of securities custody business done by branches of EU firms on German soil although the ISD says that is the job of home supervisor not host supervisor. Branches of EU banks will also have to supply some loan book information to the Bundesbank and the BAKred for example details of loans over Dm3 million ($1.78 million), and details of foreign lending. The BAKred will also disallow as own funds capital that is tied up in other financial institutions, if those institutions aren’t consolidated.
Branching in
These constraints, and minimum reserve requirements, are apparently not enough to deter foreign banks from maintaining subsidiaries in Germany. After the implementation of the EU’s second banking directive in 1994 some foreign institutions did decide to restructure their European operations. Merrill Lynch closed its bank subsidiary in Germany and set up a bank in Ireland which now branches into Germany under the European banking passport. Société Générale and
Svenska Handelsbanken also converted their German subsidiaries into branches. JP Morgan still has a bank in Germany but does its capital-intensive business in Germany through a Frankfurt branch of Morgan Guaranty Trust, New York. Morgan Guaranty gets a German passport through a US/German reciprocal agreement that US banks should enjoy the same advantages as EU banks in Germany. There is a similar agreement with Japan and agreements with Australia and Switzerland are being negotiated. One problem to sort out: Swiss banking secrecy won’t allow BAKred oversight of German bank branches in Switzerland fact: there are no branches of German banks in Switzerland.
Jan Marwede, chief executive of the Association of Foreign Banks in Frankfurt, believes the complexity of the KWG-Novelle will tempt more banks to close their German subsidiaries and branch in from other more user-friendly centres. If they want to pick one place on which to centralize their euro business if and when the euro comes it will probably not be Germany. Costs and taxation are high. Despite the 4.7 million unemployed “we can’t attract secretaries and IT people from the east. It’s like pulling teeth,” says a banker at one foreign bank branch in Frankfurt. But most foreign bank subsidiaries are likely to stick it out in Germany, for business and marketing reasons. The Japanese are comfortable with the universal banking concept. Lehman and Salomon Brothers have big German balance sheets and can do cheap repo funding in Deutschmarks for the entire group. Also, as German banks, they are under the deposit insurance umbrella, which lowers their funding costs. Salomon used its European passport to open a branch of its German bank in Milan, and the reciprocal agreement with Japan to open another branch in Tokyo. Lehman and Salomon believe having a German bank is a good marketing tool. Merrill hasn’t suffered among its peer group by branching out of Dublin into Germany, but “it may not look so good among the broader client base”, says an executive at a rival firm.
The big German banks with international operations are enjoying their respite from the tortures of CAD 1. Their EU rivals complain that the standard market risk calculations under CAD 1 are expensive for large diversified portfolios of cash instruments and derivatives. The so-called Amsterdam Accord, which allows banks to use internal value at risk (VAR) models for capital adequacy calculation, saves them no capital but limits the laborious standard calculation to twice a year. So far no UK bank has made use of the Amsterdam Accord.
The German banks are spared this interim stage and can move straight on to so-called CAD 2, which is expected to be implemented from January 1 1998. However, they are still bound by the EU solvency directive which covers large exposures.
“This looks only at the asset side, so you can’t hedge,” says Karl-Heinz Boos, managing director of the Association of German Private Banks. “In the CAD you have soft limits, so it’s not as tough as the solvency directive.”
CAD 2 will incorporate two important new concepts: the use of banks’ internal VAR models for capital adequacy purposes as recommended by the Basle Committee on Banking Supervision in January 1995 and capital limits for non-professional commodity and commodity derivative positions. The Basle guidelines will be enforced in the US and some other G-10 jurisdictions at the same time as CAD 2. So German banks are unencumbered by the CAD 1 standard market risk calculation, or by the marginally better Amsterdam Accord. They can go straight to CAD 2 and the use of internal models. “The Germans have been bloody smart about this,” says a London-based finance industry lobbyist. “The German banks have been saying: ‘Let’s go straight to VAR’. Once CAD 2 is in place they can have one-stop implementation. Our banks have had to go to standard rules for two years, that has meant a big investment in systems.”
CAD 3, say European Commission DGXV officials, is bound to follow. CAD 3 is addressing concerns that VaR, even at the recommended 99% confidence level, with 10-day holding period and based on one-year data, multiplied by three, doesn’t sufficiently cover specific risk, and event risk. At the moment the Basle guidelines and CAD 1 disagree on specific risk, Basle starting with an 8% requirement for the riskiest instruments and CAD 1 wanting only 4%.
Knock-on effect
German banks could start using their internal models from August 1, if the BAKred were to approve them. But that is unlikely. Only Deutsche Bank and perhaps DG Bank have models that are close to giving a snapshot of the bank’s global risk positions. Although the BAKred team is now visiting the banks to inspect the models, it will hardly expect reporting to begin in earnest until January.
By then, German private banks may have begun to sort out their own anti-competitive gripe with the savings banks. They have complained to Brussels that Westdeutsche Landesbank (WestLB) and other members of the savings bank sector have benefited from virtually free injections of capital from their affiliated state-owned home-building development companies. The private banks say that free capital allows WestLB and others to undercut them in the domestic market.
Germany’s foot-dragging on the European directives has made it more difficult to implement them correctly in other EU states. The question of home-country and host-country supervision is one example. On paper the home country should supervise branches of securities firms throughout the EU. But if a country has not implemented the investment services directive the situation becomes complicated. German securities firms cannot yet branch under the European passport into other EU countries because the BAKred doesn’t yet supervise them. But German banks have the passport under the second banking directive, even though Germany hasn’t complied with the CAD. “It might be possible for a host country to challenge this, but none has,” says an EC official.
Until Germany implements the KWG-Novelle it won’t be possible to test whether branches of financial institutions under an EU passport must comply with the tougher German regulations on reporting, custody, etcetera. “It’s still not clear whether you have to comply with host rules,” says Peter Beales at the London Investment Banking Association.
The EC is still wrestling with the problem of where cross-border business is deemed to be done is it at the site of the transaction or at the point of contact with the client? Around Easter it was expected to issue a second discussion paper suggesting, as other experts have done, that it should be at the site of the transacting firm. “The clue is to distinguish where the business is normally done the site of its so-called ‘characteristic performance’,” says Beales. Logically “you can’t regulate a firm if it’s not in your country”. However, some experts argue that the cross-border transaction should comply with local conduct-of-business rules. This opens up the nightmare of a cross-border dealer having to know and comply with up to 14 sets of conduct-of-business rules. “Until these issues are resolved,” says Beales, “the benefits of the ISD are open to debate.” A frustrated member of DGXV says: “These directives are only efficient if all countries transpose them. A country which hasn’t transposed them creates obstacles to the mechanism.”
But the other concern, from Matthew Elderfield, London representative of the International Swaps & Derivatives Association (Isda) is that some countries have used the transposition of directives as an excuse to reregulate, especially on derivatives. For example, “inter-professional dealing is being subject to conduct-of-business rules, even though the ISD doesn’t require it”, he says.
In two years’ time, when the directives have settled down and interpretations have been reconciled, the spat over Germany may be remembered as a storm in a teacup. “There’s no feeling that Germany’s image has suffered as a financial centre,” says Boos at the Association of Private Banks. “The delay is only one or one-and-a-half years.”
And in two years any EC proceedings against Germany will have died a death, as an Italian example shows. The EC opened proceedings against Italy in 1991 for forcing firms doing securities business in Italy to incorporate as a Sim (societa di intermediazione mobiliare), in contravention of the Treaty of Rome. The European Court finally reached a judgment against Italy in June 1996 for which fines of between Ecu120,000 and Ecu160,000 a day were recommended. But Italy had already drafted a law to put the matter right and it was passed the following month. “There’s still a possibility that someone may sue the Italian government for damages,” says an EC official wistfully.
