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Why carving China's banks out from TLAC is wrong

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By Owen Sanderson
11 Nov 2014

Journalists sometimes have to choose between being fast and being right. The Financial Stability Board, with its Total Loss Absorbing Capacity (TLAC) plans, has chosen to be fast, and a weaker financial system will be the result.

Did you feel it? Too-big-to-fail just ended, right on Mark Carney’s schedule. The Financial Stability Board of the G20 group of countries, which Bank of England Governor Carney chairs, promised that by this November, it would reach an agreement on ending too-big-to-fail in global banks, by creating rules that made sure bondholders go in front of the bus to defend taxpayers and depositors.

“Agreement on proposals for a common international standard on total loss-absorbing capacity for Systemically Important Banks (SIBs) is a watershed in ending “too big to fail” for banks,” said Mr Carney. “Once implemented, these agreements will play important roles in enabling globally systemic banks to be resolved without recourse to public subsidy and without disruption to the wider financial system.”

This is supposed to remove the moral hazard from the wholesale funding of the banking system, while keeping it alive and well in the insured deposit segment. Retail bank creditors will be safe; unsecured bondholders will have to face the risk that they will not get their money back, and, it is hoped, will respond by limiting the risks banks take with their money.

Not a moment too soon, you might think; the UK decided to bail out Northern Rock almost seven years ago, and the rules will not go live until 2019, by which time the crisis will be more than a decade old.

The rules themselves are an impressive attempt to deal with a mess of intractable problems, with compromises on difficult issues like whether local regulators can burn senior creditors of their banks, when one of the senior creditors is the parent banking group. Compromises have been made on resolution funds, on the absolute level of loss absorbing capacity, and on the balance between making requirements Pillar 1 (required from everyone) or Pillar 2 (required by local regulators).

But one area is notably free of compromise.

“G-SIBs that are headquartered in emerging markets will not, initially, be subject to the Common Pillar 1 Minimum TLAC requirement,” according to the consultation paper.

Only three institutions on the list of global systemically important banks (the only institutions which will be subject to the new rules at first) are headquartered in anything resembling an emerging market, and all of them are Chinese — Agricultural Bank of China, Bank of China, and Industrial and Commercial Bank of China.

Free of justification

The communique is notably free of any justification whatsoever for this exemption. The only concession to the European and US view of the rules is the word “initially”, which raises the possibility that one day it could be renegotiated.

But for now, it stands firm as an example of extortion. The FSB achieved its November deal, and Mark Carney keeps his messianic aura as FSB chief (he’s recently been given the gig for another three years), in return for including a carve-out that you could drive a bus through.

This was always expected to be a sticky patch in the negotiations. The Chinese, along with other emerging market FSB members like Mexico, Brazil, India, and Russia (none of whom host any G-SIBs) could quite reasonably argue that their banks had nothing to do with the recent financial crisis.

 The three Chinese institutions on the list are probably on the list because of extreme size.

The list of G-SIBs is determined by various indicators, including size, intra-financial system liabilities and assets, payment activity, OTC derivatives, assets under custody and primary underwriting. But absolute size has the greatest weight.

The three Chinese banks are retail and commercial focused banks, which happen to have dominant positions in a huge domestic market. Their investment banking arms are not at the centre of the webs of derivative and repo market financial interconnection, which made the collapse of Lehman such a global disaster. They make a lot of loans, but they do not have the enthusiasm for globe-trotting exhibited by the other G-SIBs. Global trade and manufacturing are lubricated by others.

No free pass

But that does not mean they should get a free pass. Financial regulation, especially at the global level, should be about shaping a resilient system that can survive the next round of shocks, not passing out blame and punishment for the last crisis.

Every regulator is pretty much satisfied that they don’t have another US subprime mortgage bubble about to blow up underneath them. But then identifying a crisis which happens to look exactly the same as the last one will be easy, and it should work much better thanks to the waves of regulation passed since then.

Which is why we can be sure the next crisis will look different. By forcing the exemption of their banks from global bank safety rules, the Chinese authorities are either saying that the rules will not help prevent crisis, or that their banks will not cause it. Neither implication is a comfortable one.

Plenty of international investors (despite the recent hunger for Bank of China's additional tier one issue) have reason to question aspects of the Chinese financial system.

Growth in shadow banking, property valuations, accounting standards, local authorities lending — all have worried investors in the recent past. All of these, or none, may cause trouble in the banking sector. The point is that we cannot know.

Perhaps we can be confident that China is happy to bail out its mostly state-owned banks today, but as they become more internationally active, assertive and as China liberalises its economy, they will likely push into other areas of activity. Nobody believes the potential of Chinese financial liberalisation is at an end or will go backwards.

The FSB's rules do not even go live until 2019, and one presumes they would like their system to have a reasonable shelf life. The consultation published yesterday could set up the global financial architecture for 2030. The FSB should take that mission seriously, and get back to the negotiating table until they have a deal. If they do not, how can they expect anyone else to take TLAC seriously?

By Owen Sanderson
11 Nov 2014