War the worlds: reforming world financial regulation is about to get nasty. Berlin, call your office!

• Author: Engelen, Klaus C.

On both sides of the Atlantic, the worlds of finance and politics expect that the next twelve months could bring about the most dramatic changes in financial services regulation in decades. After talking for months about the reasons that led to the financial meltdown and after agreeing on the outline of a solution, political leaders will begin to come up with concrete proposals. From that point on, behind the scenes and in the open, the power grabs between the United States and Europe, and within the European Union, will start to get nasty.

From a German perspective, this could be bad news. Key supervisors, regulators, and experts in the field of international financial diplomacy see a real danger that Germany could be distracted during negotiations by its upcoming elections. The consequence could be that Berlin won't come up in time with the strategy and clout it needs to defend its vital financial and economic interests during dealmaking on the EU and global levels. "Sorry to say, neither government nor legislators nor the private sector has the looming fights about securing German interests in the coming reform battles on their radars," laments a Bundestag financial market expert.

Absorbed in rescue efforts for ailing enterprises and banks--which in return are hoarding ever-cheaper funds while cutting loans to corporations and the politically important "Mittelstand"--the Berlin government is only focusing on the September 27 national election.

But the 0.3 percent growth in the German economy for the second quarter of 2009, after four consecutive quarters of negative growth, has boosted Angela Merkel's bid for re-election as chancellor. The 85 billion [euro] ($121 billion) in economic stimulus measures passed by the Berlin coalition government in two major stages prevented the slump, helped by Germany's 5 billion [euro] carscrappage scheme. "The government can claim part of the credit for this recovery, for stabilizing the banks and implementing the short-term plan," says Goldman Sachs economist Dirk Schumacher.

In early summer, the coalition government of Chancellor Merkel and foreign minister Frank-Walter Steinmeier began drifting apart. Cabinet members are walking in different directions. This was dramatized by recent do-it-alone actions by Germany's new economic minister Karl-Theodor zu Guttenberg. This aristocrat from the Bavarian CSU has become an overnight political star. Despite membership in the Merkel cabinet, zu Guttenberg received a lot of political mileage from opposing Merkel's rescue concept for Opel and talking about it publically. Recently, he single-handedly even put forward new legislation to restructure failing banks, although his ministry has no responsibility in this area. He simply adopted an alternative insolvency law concept from the international law firm Linklaters. The Linklaters plan would make it easier to restructure even big banks and thus prevent situations such as that of the failed mortgage financier Hypo Real Estate, where the German government had to amend the insolvency laws in order to have the option of expropriation included.

Germany's financial sector in particular its "three-pillar" banking system comprising private commercial banks, public sector Landesbanks, and savings banks and cooperative banks--has been severely damaged by the financial crisis. German banks, represented at the EU level through the European Banking Industry Committee, may face major power struggles on a broad range of financial market reform proposals. Some see as helpful the fact that a German banker, Karl-Peter Schackmann-Fallis, is presently heading EBIC. Schackmann-Fallis is executive member of the board of the German Association of Savings Banks.

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MANY DISPUTES BUT SOME COMMON GROUND

Chancellor Angela Merkel and Finance Minister Peer Steinbruck have found some common ground on reforming financial market supervision and regulation. They did a lot of finger-pointing at Wall Street and the City of London bankers who produced and distributed those toxic financial products that are now bringing down major European banks. Preparing for the G20 Washington financial summit in November 2008--in particular the forty-seven--point "Action Plan" and the "Declaration of Financial Markets and the World Economy"--the chancellor's office and the ministry of finance worked closely together. This is not surprising, since both were deeply involved in the rescue operations for failing banks beginning last year (IKB and KfW, WestLB, SachsenLB, HRE, and Depfa). After the Lehman Brothers demise with its systemic fallout, Merkel and Steinbruck were forced to go to Parliament and ask for major budget increases and guarantees to put in place a more comprehensive rescue structure: the Financial Market Stabilization Fund, or SoFFin. This new vehicle was immediately used to support Commerzbank AG as it faced huge writedowns in the assets of Dresdner Bank AG that it had taken over a few months before from the insurance giant Allianz AG.

Both Berlin governing coalition partners agree broadly that there is an urgent need to push through long-overdue repairs of the international financial architecture. High on that repair list is getting rating agencies, as well as unregulated entities such as hedge funds and private equity firms, under supervision. Other reform priorities include cleaning up offshore centers, changing the compensation incentives for bank managers, making sure that banks retain an interest in the securitized products they issue, and finally, streamlining European financial market supervision structures. There, the EU Presidency agreement of June 2009 is an important step. Legislative proposals for a new EU regulatory framework--as it was decided--should be in place in the course of 2010.

THE LOOMING "BATTLE OF THE BIG BEASTS"

Looking at the unfolding drama of rewriting "new rules of the road" for financial markets, The Economist in its July 23, 2009, print edition talks of a looming "battle of the big beasts" and of "mutual suspicion and national interests" that "underlie European rows over financial regulation." However, judging by the noisy and partly hostile opposition to the new rule changes that U.S. President Barack Obama is proposing in his financial white paper, some "battle of the big beasts" is also raging on the other side of the Atlantic.

In broad terms, the United States and Europe seem to be in agreement that they want better global cooperation, better systemic oversight, tougher bank regulation, and more supervision of unregulated entities and products such as hedge funds and derivatives. But the room for regulatory convergence across the Atlantic remains limited, in spite of the fact that the newly enlarged Financial Stability Board was given the G20's mandate to streamline the global regulatory framework with the lessons of the present financial meltdown in mind. This would mean, in particular, tougher supervision of systemically important "large complex financial institutions" and higher global standards on capital requirements.

But as key European supervisors and other experts admit, "There is not much evidence of U.S.-EU coordination at the level of discussing concrete reform proposals." They see the focus of Obama's reforms as bank regulation and consumer protection. They are disappointed that the problem of overlapping supervision agencies was not resolved in the United States because of powerful vested interests. In their view, hotly contested issues remain. For instance, the EU directive on alternative investments would not be acceptable to the Obama administration and the U.S. Congress since it would go much further than just requiring registration. The European Commission has put forward an alternative investment directive that would force hedge funds and private equity funds to seek regulatory authorization, report their strategies, and set aside capital against losses. Regulators would be able to set limits on borrowings.

European supervisors also see a problem in how, under the new U.S. regulations, banks would be required to retain an interest in securitized asset-backed securities. The European Union is opting for a much broader requirement, forcing banks to keep an interest in loans that are securitized and then sold.

European supervisors and regulators note major differences between the United States and European Union in how credit rating agencies will be supervised and how regulated derivative products and customized derivatives should be handled. They realize that the Obama administration, in order to get its regulatory regime change through Congress, must take the powerful commercial interests of Wall Street into account.

THE BATTLE WITHIN EUROPE

With a backdrop of such looming transatlantic regulatory battles, Europe itself also seems to be on the brink of an internal "battle of the big beasts." Going by the newspaper headlines, some old fights between London and the Continent's heavyweights, Germany and France, have...