Geithner accuses the EU of protectionism in financial services

The Financial Times has caught wind of a letter sent by U.S. Treasury Secretary Timothy Geithner to to the EU’s Michel Barnier. In only thinly-veiled language Mr. Geithner accused the EU of financial protectionism for the way Brussels is moving forward with rules to regulate hedge funds and other parts of the shadow banking system. This marks the most open sign of the deteriorating US-EU relationship on matters of financial reform.

The letter is embedded below.

Geithner Letter to Michel Barnier accusing EU of Protectionism

This latest development should not come as a surprise given the outline of EU-US disputes I put forward on 9 March. Europeans have shut the American firms out of sovereign bond deals. Meanwhile, European firms are fully able to participate as underwriters of Build America Bonds that are racking up huge fees for large banks.  I began my post Wall Street barred from European bond sales in retaliation for credit crisis saying:

We have a bit of a divide developing between the EU and the U.S. on banking and bank reform. The most significant move in this tiff has come in retaliation for Wall Street’s role in helping countries like Greece hide their debt burdens. According to the Guardian newspaper, all American banks have been shut out of the sovereign bond market in Europe. While many might think the U.S. government does not have a role to play in this dispute, I know from my own experience as a diplomat that the U.S. government is very aggressive about advocating for U.S. firms abroad.

I ended the bond sale piece noting:

how much of this is just politics.  In the Greek case, up to fifteen banks may have helped Greece hide debt. Yet, the focus here is on Wall Street firms – I suspect purely for demagoguery. Should we expect a tit-for-tat move of some sort?

In this context, Geithner’s letter makes perfect sense.  The financial services industry is an important profit center for American business. Therefore, Geithner feels compelled to advocate on its behalf in Europe – as the American government is prone to do. Think of Geithner as lobbyist for American finance in Europe. The difference between the US Treasury Secretary and a mere lobbyist, however, is the veiled threats Geithner can make.

What appears to be happening is that the Americans are focused on regulating the banks by trying to force them to reduce size via size penalties, size caps, or extra regulatory premiums. The Europeans, on the other hand, are much more worried about ‘the wild west’ of the shadow banking industry that includes hedge funds. The fact that most of the EU is heavily dependent for lending on banks which are thinly capitalized too big to bail behemoths may explain why there is such resistance to size caps in Europe. The British have sided with the Americans in this dispute as London is home to a large hedge fund community.

This divide further explains why Greek Prime Minister George Papandreou asked US President Barack Obama to crack down on American speculators in the credit default swaps market when they met recently. This also explains why the Europeans are looking to ban naked credit default swaps outright. The Americans are resistant to this idea.

White House officials said Greece should focus on righting its economy and lowering its crushing debt.

“This is something the Europeans can, and should, solve on their own,” White House spokesman Robert Gibbs said, as Mr. Obama and Mr. Papandreou met in Washington on Tuesday.

The White House’s cool response to Greece’s call for a regulatory crackdown shows there’s still no consensus on what – if anything – to do about the problem of speculators.

After the meeting, however, Mr. Papandreou insisted that Mr. Obama reacted favourably to European ideas on curbing speculators.

–White House resists Greek pressure for crackdown on speculators, Globe & Mail

The spin after the meeting makes sense. Obama is still fixated on showing he is friendly to Wall Street. Hence, spokesman Gibbs’ remarks. Papandreou needs to cast blame on speculators in order to deflect attention away from the government in order to counteract social unrest domestically.

Nevertheless, on the continent, we hear politicians looking to attack the shadow banks time and again. The latest in this move is Bundesbank head Axel Weber.

The Irish Times reported on this.

Financial regulation should be strengthened by improving existing rules on how much capital banks must hold rather than by capping the size of banks or setting up bailout funds, the head of the German Bundesbank has said.

Speaking at Trinity College Dublin, Dr Axel Weber, a member of the European Central Bank’s governing council, criticised US plans to limit the risky activities of banks and to cap the size of the institutions. The plans would be “the most severe intervention” by a regulator in the sector, he said.

Such a move could lead to an unregulated “shadow banking” system where riskier investment banking, hedge funds and private equity firms’ activities would be forced outside regulated banking.

I seriously doubt the EU and the US will find common ground on these issues. I hope I am wrong as a number of smaller EU countries have taken issue with specific points in the proposal. However, if these disputes cannot be resolved – or worse still, if they escalate – the likelihood that another financial crisis spreads catastrophically is much greater.