UK Treasury China-bank charm offensive exposes regulatory arbitrage

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The UK Treasury’s courtship of Chinese banks highlights, in part, London’s relatively flexible regulatory regime for foreign banks – in contrast to the Fed. It also opens up a broader debate about subsidiarization and global banking models, more generally, amid regulatory turf wars.

The UK government caused a flutter of controversy last month when chancellor George Osborne said he had asked the banking watchdog to allow Chinese banks to set up foreign branches in the UK. Chinese banks have ostensibly hitherto resisted establishing local London operations, in part due to fears over regulatory demands they operate fully funded subsidiaries, which would have led to punitive set-up costs. Osborne’s overture to China’s banks drew gasps from some industry participants, who argue that the conciliatory approach stands in stark contrast to the prevailing attitude of the Bank of England in recent years to foreign banks looking to set up a UK presence. That approach, nurtured by former Bank of England governor Mervyn King, was forged in the heat of the Icelandic banking crisis, when UK depositors in London branches lost money. Since then, UK authorities have encouraged foreign banks to set up fully funded subsidiaries that do not depend on their parent companies for their security. But any outrage over perceived favouritism is misplaced. One Bank of England source said: “Even if we wanted to insist on, say, [an ex-UK well-established European bank] setting up a London subsidiary, there is nothing we can do to enforce that. We could be taken to court.” What the chancellor’s Chinese charm offensive does highlight is further evidence of the lack of a unified policy between national regulators on the issue of subsidiarization – an increasingly high-profile topic in the banking industry that has big implications for firms looking to maintain a global presence. While the UK’s Prudential Regulation Authority looks at applications by foreign banks on a case-by-case basis, the Federal Reserve is advocating a harder, one-size-fits-all approach. US foreign banking organization proposals call on foreign banks’ US entities to comply with local leverage rules and meet liquidity requirements set by both the Federal Reserve and Basle III, which some dub a de facto form of subsidiarization. The FBO proposals were put forward by Fed governor Daniel Tarullo in response to moves by European banks to restructure their US operations to avoid having to fund them locally. By contrast, the European Central Bank, which will become the single regulator for eurozone banks in 2014, has not communicated any philosophy on subsidiarization. “The UK’s case-by-case approach goes back to longstanding practices at the BoE,” said Nicolas Veron, a banking expert at Brussels think-tank Bruegel and Washington-based Peterson Institute for International Economics, who argues that while the Chinese charm offensive may be politically motivated, it is not reckless. “Chinese banks have big balance sheets backed by the sovereign. The risk of default is low; it makes sense for the Bank of England to be more relaxed about them setting up,” he said. The level of risk would also depend on the model that bank is proposing: if a Chinese bank is looking to offer deposits to UK customers, then the Bank of England’s deposit protection scheme would offer protection. Veron said: “There is a clear change of tone at the Bank of England following the change of governor and this is reflected in the favourable stance towards Chinese banks.” “There is a connection between cross-border financial integration and globalization, so the issue of subsidiarization is an important one. There has been very little analysis or understanding of the issues, and of the economic trade-offs in terms of growth and stability.” Some industry participants say that excessive and disjointed regulation is leading to de-globalization in the banking industry, with national banks, particularly those who have been bailed out by taxpayers, focusing scarce balance sheet resources more on their home markets. A report published in April by consultants Oliver Wyman estimated “disjointed regulation" could cost the banking industry as much as $15 billion. The report said: “The fracturing of global banking... has become one of the largest challenges for wholesale banks, taking two to three points off return on equity. Disjointed international policies pose the biggest threat.” Oliver Wyman warns that banks will have to make a choice between “a hub-based model accepting reduced earnings power... or accepting the higher costs of a multi-local model with fragmented balance sheets."

Banks may be steeling themselves for the greater cost of funding foreign subsidiaries, and may gnash their teeth at what they see as preferential treatment towards Chinese banks, but they should prefer the current fluid situation over onerous one-size-fits-all regulation.