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'America first' in banking sector could ignite global crisis

White House Chief Strategist Stephen Bannon speaks at the Conservative Political Action Conference (CPAC) in National Harbor, Maryland, February 23, 2017.
Joshua Roberts | Reuters
White House Chief Strategist Stephen Bannon speaks at the Conservative Political Action Conference (CPAC) in National Harbor, Maryland, February 23, 2017.

Following the Trump Administration's order for a regulatory review on U.S. banking rules, some prominent Republicans in Congress have joined with the new administration in discussing the possibility for the United States to exit or revisit its role in global banking agreements.

In a letter to Fed Chair Janet Yellen, written by Rep. Patrick McHenry, he calls the Basel III Accords "the result of an opaque, decision-making process." Comments from prominent GOP senators like Pennsylvania's Pat Toomey and Idaho's Mike Crapo echo this.

To Basel and global banking regulation critics, the removal of regulation presumably means reduced costs and increase lending opportunities for banks. Since banks have to hold extra capital for riskier loans, reducing or removing these requirements may entice them to extend credit to more borrowers. But one unintended consequence of this argument is the potential reduction of global financial stability. Coupled with a new bent towards economic nationalism, these policy changes in the U.S. may not only decrease trade between the U.S. and other nations, but could also reduce the ability and willingness of U.S. financial institutions to lend and invest abroad.

"Bankers are not worrying about systemic risk and financial crises – they are more worried about increasing return on equity for shareholders. This is understandable. But the regulator's role in the process is to make sure that the bankers don't get too overzealous in this pursuit."

When banks lend money to other banks across international borders it can reduce the likelihood of a systemic financial crisis similar to the 2008 global financial meltdown. There's no way to completely eliminate risk, but the structure of the banking system structure can help to minimize the probability of a crisis.

What role does bank lending play in assuring global financial stability?

First, there can be a reduction in foreign banks' reliance on short-term funding like deposits. A reliance on short-term funding can create difficulties for banks when credit is in short-supply, as it becomes more difficult for banks to roll over short term funding, which in turn can create liquidity problems or make it difficult for banks to meet their obligations – an occurrence that can start or dramatically worsen a financial crisis.

This effect is most pervasive when funds flow from more well-regulated or more stable countries to their less regulated and less stable counterparts. According to calculations from the NYU Volatility Institute, the U.S. is currently among the more stable financial systems in the world on a GDP-adjusted basis. Moreover, U.S. banks had over $3 trillion in foreign assets at the end of the third quarter of 2016, according to the Bank for International Settlements. This makes the United States one of the largest players in the global financial system.

Second, both countries that are net lenders and countries that are net borrowers can benefit by diversifying away risk specific to their country, as assets and liabilities are now spread among more counterparties, though common macroeconomic shocks may reduce or eliminate this benefit.

The problem of reduced activity among international financial institutions and a reduction in short-term funding is not limited to only foreign entities that receive funds from U.S. banks. Funds received from abroad can help reduce the propensity for another financial crisis to occur in the United States.

Two ways to leave the global banking order

There are two ways by which a reduction in foreign lending could occur.

First, the U.S. government could make it difficult for U.S. banks to participate in the international banking system. The talk that the United States will decrease its participation in international regulatory agreements on banking like the Basel Accords is one example. Global financial stability and cross-border bank activity are tied in many ways to international agreements like Basel, which create an even playing field among banks that do business globally.

Second, the level of investment by U.S. companies could increase in part due to the recent wave of economic nationalism, thus increasing the demand for credit at home, and constraining the ability of foreign borrowers to access U.S. credit. This scenario may generally be a positive one for the U.S. economy. However, a push for more domestic lending could force banks into lending to borrowers with lower credit quality than what is optimal for their portfolio. This is not unlike the lending climate prior to the 2008-09 financial crisis, where the demand for mortgage loans exhausted the supply of good quality mortgages and pushed lenders toward subprime borrowers.

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Banks are very much in favor of the removal of these regulations. Bankers are not worrying about systemic risk and financial crises — they are more worried about increasing return on equity for shareholders. This is understandable. But the regulator's role in the process is to make sure that the bankers don't get too overzealous in this pursuit and that they are pushed toward more responsible decision-making.

As the political climate in Washington changes, it is important for policymakers to consider the effects of limiting trade and interactions with foreign markets. There are distinct benefits that can be achieved by maintaining the reach of the U.S. financial system at a global scale.

The best answer might be to leave well enough alone, instead of adding new impediments for firms and financial institutions to play a role in global markets. By increasing barriers to trade, exiting international banking agreements, and shutting out the rest of the world, the United States' withdrawal from global markets will reduce the impact of one of the United States' most important exports: financial stability.

By John Sedunov, assistant professor of finance at the Villanova School of Business

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