Europe Can Teach U.S. a Few Lessons on Reform
Aspects of the debate over the Bush administration's proposal to reform the U.S. banking system are being watched with a mixture of amusement and curiosity by Europeans.
While U.S. banks, regulators, and legislators agonize over whether to permit interstate banking, Europeans have created a single community passport that will sweep away national barriers and give rise to a single banking license throughout Europe.
In 1993 European banks will be free to open branches and provide services across the Continent. They face only minimum regulatory intervention from the host states, that is, the states in which the branch or service is provided, as opposed to the state in which the bank has its headquarters.
The E.C.'s Bigger Challenge
The European Community's exercise in reform started from a base that was more restrictive than the U.S. regulatory system. Member states were divided politically, culturally, and economically. Despite these handicaps, they have created a system that only the most optimistic advocates of banking reform believe could be achieved in the United States in the foreseeable future.
This is all the more remarkable given that European banks in each member state operate in a different economic environment.
This article considers how U.S. banks might operate if the new European system were in place in the United States. This is done to illustrate the competitive advantage that European banks will have when the new system is in place in 1993.
It is not intended to suggest that the system could be uprooted from Europe and applied in the U.S. without adaptation, but rather to show how far the Europeans have surrendered a parochial approach to the banking system in the interest of economic advancement and to provide a practical focal point for the current debate in the U.S.
The guiding principle of the new system is home-state control. A bank licensed in one member state of the community is free to branch into other member states with minimum supervision by the regulatory authorities of the host state.
If it were in force in the U.S., the European banking directive would, for example, permit a bank chartered in New York to open a branch in Colorado, where it would be subject to limited supervision by the Colorado regulators. The bank would first have had to comply with nationally specified procedural requirements.
The main procedural requirements would be for the bank to give its home-state regulator notification of its intention to establish a branch in another state and to provide certain information (the names of the people responsible for the branch, types of business contemplated, etc.).
Unless the home-state (New York) regulator had reason to doubt the adequacy of the organizational structure of the bank, it would be required to convey the specified information to the host-state (Colorado) authorities within three months.
Further Branching Easier
The home-state regulator could refuse to do so only if it had good reasons, and the bank would have recourse in the courts with respect to any such refusal. Once a bank opened one branch in a host state, there would be no further notification required if the bank wanted to open additional branches in that state.
Once the home-state regulator had passed on the information that its bank wished to establish a branch in a host state, the host state would have up to three months to prepare for the supervision of the bank. Then the branch could commence operations. The responsibility for the supervision of the bank, including the supervision of activities undertaken by its branches in other states, would rest with the regulator in the home state.
The competence of the host-state regulator to supervise the activities of branches of out-of-state banks would be restricted to the supervision of liquidity, which function it would carry on in conjunction with the authorities in the bank's home state, and the imposition of conduct-of-business rules relating to matters such as consumer protection, provided these do not treat out-of-state banks less favorably than local banks.
In most significant matters, such as solvency or permitted areas of business, the host-state regulator would defer to the home-state regulator's control and supervision over the branch within the host's jurisdiction.
Right of Inspection
The home-state regulator would have the right to inspect the activities of a branch in a host state with respect to matters such as the supervision and monitoring of liquidity and solvency and internal accounting procedures. The home-state regulator would be limited as to when it could revoke a bank's authorization.
Once a home-state regulator revoked a bank's authorization, it would have the obligation to advise any host-state regulator in which that bank had branches, and the host-state regulator would be obliged to take appropriate measures to prevent the bank from undertaking any further business in its territory.
The risk for host states is that certain states will adopt liberal regulations on matters such as solvency, and banks will become established in such states and then set up branches elsewhere. One or two irresponsible states could thus put the banking structure at risk.
A Common Set of Rules
The European Community has dealt with this problem by laying down minimum requirements that member states must incorporate into their banking rules. These concern matters such as solvency ratios, accounting standards, rules on consolidated accounts, the control of large exposures, and deposit guarantee schemes.
A major difficulty of the European scheme concerns the question of what services are properly regarded as banking services and thus subject to home, rather than host, state control. The European answer to this is to set out a list of activities that a bank may be authorized to engage in. A bank authorized to carry out these activities in its home state may also carry out such activities in host states.
This is the case even if the host state does not permit its own banks to conduct such activities. The list of permitted activities is wide and includes, in addition to traditional activities such as deposit taking and lending, matters such as securities trading, fund management, and underwriting. The latter activities are not permitted to U.S. banks.
The effect of the system is therefore to bring about deregulation by market forces. If, for example, Colorado had a more restrictive regime than that of neighboring states, banks would be encouraged to move their headquarters to neighboring states to take advantage of the rules in such states while maintaining branches in Colorado. The Colorado branches of such banks would be permitted to engage in activities not permitted to Colorado banks. In order to prevent this, Colorado would be forced to bring its regulatory rules into line with the more liberal states.
The European rules seek to prevent member states from authorizing subsidiaries of banks that are set up purely to evade the stricter controls that operate in the state in which the bank has its main connection. However, doubt has been cast on the efficacy of these provisions, particularly as they will depend on action being taken by member states that have laxer regulatory regimes and may therefore have no interest in discouraging the establishment of subsidiaries within their territory.
The new European system thus goes beyond the Bush administration's proposal, which envisages that, in the case of state banks, each state will determine whether to authorize interstate branching powers for its own banks, and such branches would be restricted to activities permitted to banks chartered in the host state.
After a three-year transition period, national banks would be permitted to establish a branch in any state, although even they would be subject to state laws on interstate branching. So, for example, a state that prohibited branching across county lines would be able to impose a similar restriction on branches of national banks.
In practice, despite early successes, there is a real chance that the full administration proposal would not be acceptable to Congress and that a compromise scheme giving states the opportunity to "opt-out" of a system of interstate banking will be adopted.
The European structure also is broader than that proposed for the U.S. in that it will eventually encompass not just banks but other financial institutions. The community's proposed Investment Services Directive and associated legislation will create a single license for nonbank securities houses that will operate like the banking directive.
The European debate on the single banking market proposals was insignificant compared with the passions the topic has aroused in the United States. In February the National Governors' Association passed a strong resolution demanding the preservation of the states' role in banking. There is concern that decisions will cease to be made locally - money will be taken out of Des Moines and given to New York, London, or Belgrade. A more substantial concern is that states would lose their ability to regulate such things as lending policy and would lose tax revenues.
An Apparent Paradox
Why is it that the Europeans, who are politically and culturally more divided than Americans, are close to establishing a unified banking system while in the U.S. the proposal for a more restricted system has caused anguish in the banking community and elsewhere?
One reason is that local banks in Europe do not carry the same degree of political influence that smaller U.S. banks do. And, in so far as there is a conservative lobby, the political structures of the European Community provide fewer opportunities for such a lobby to carry weight.
It may also be that the relation between a healthy and competitive banking system and regulatory reform has not been fully appreciated in the United States, where attention has been focused on short-term issues such as the viability of the deposit insurance system.
Loss of Status
U.S. banks have fallen dramatically from their prominence in the international marketplace. In 1983, three of the top 20 banks in asset size were U.S. banks. By 1988, the top U.S. bank, Citibank, was 24th. The U.S. Treasury report states: "A sound, internationally competitive banking system is critical to the nation's economic vitality and the financial well-being of our citizens."
Problems concerning regulatory structure and outdated legal restrictions on bank competitiveness are identified as two of the four interrelated parts of the current problem. Yet the report does not address reforming the regulatory structure until the one of the last of 21 chapters.
If U.S. banks are to become more competitive, lawmakers may benefit from a closer scrutiny of developments outside U.S. boundaries. While no one would advocate that the European model should be transplanted to the United States, it is evident from the developments in the European Community that banking reform can be achieved without tears and that broader interests can overcome local concerns.
Mr. Coleman is a partner in Norton Rose in Brussels, and Ms. Hart is with the law firm's London office.