Braking the Banks

The proposals have sparked grumbling among bankers, especially in Europe, because the requirements would crimp their profitability. JPMorgan this month estimated that, if key measures like increased capital requirements are implemented, the average return on equity of investment banks would drop by one-third. "It's out of the question to systematically increase layers of capital in the banks if there's no supplementary risk," says Ariane Obolensky, managing director of the French Banking Federation. But the tide is against such critics. As Stark of the ECB put it in a speech this month, "the simple statement that 'if banks are too big to fail, they are probably too big to exist' is a reasonable rule." The postcrisis financial system, he predicted, "will probably place greater emphasis on traditional banking activities, which tend to produce lower margins, but are also more robust, less risky and less volatile."

Taming the Markets Regulators on both sides of the Atlantic are trying to limit abuses that led to the meltdown, such as the reckless issuance of subprime mortgages. In the U.S., the Treasury Department and lawmakers are seeking to bring greater transparency to the arcane world of financial derivatives by requiring the trading of them to be done through central clearing houses. Meanwhile, Trichet's group of central bankers wants banks to put up additional capital if they engage in especially risky types of financial market transactions. As the financial services industry braces for tougher oversight, it's keeping its fingers crossed. "There's a lot of wariness about all forms of financial market activities and that's perfectly understandable," says Richard Metcalfe, global head of policy at the International Swaps and Derivatives Association. "There's a huge amount of political pressure to do things. Let's do it in a way that is intelligent." (See "Turning Point for the Global Recession?")

Edging Toward the Exit U.S. Treasury Secretary Tim Geithner this month announced that the U.S. is starting to phase out some of its emergency support for banks and financial markets. But he pointedly made no mention of a full-blown "exit strategy," saying that "we must continue reinforcing recovery until it is self-sustaining." When and how governments and central banks pull back is a critical issue that still needs to be coordinated. One of the risks is that inflation could soar due to the explosion of national debt in many countries during the crisis. And early signs suggest governments have wildly different strategies. In Germany, for example, Chancellor Angela Merkel promised tough action to bring down the budget deficit, while in France, President Nicolas Sarkozy is looking to add to the country's debt though a huge government-bond issue next year. Such divergences are already causing alarm. Unless exit strategies also address the long-term sustainability of public finance and other challenges, Stark says, "the current crisis is bound to be exacerbated by a sovereign debt crisis."

Fixing Those Bonuses Almost everyone thinks something should be done to curb big paydays for bailed-out bankers, but solutions are elusive. Finance Ministers of the G-20 nations earlier this month agreed that bonuses should be more clearly tied to performance, but Britain and the U.S. resisted demands by France and Germany to have them capped. Sensing the prevailing political winds, some bankers are already moving to forestall draconian new rules. The Dutch banking association announced that its members have agreed to cap bonuses and severance pay. And in France, bankers have been so frequently called to the Elysée Palace this year to be chided in person by Sarkozy that they're rewriting their rules.

Andreas Schmitz, head of the Association of German Banks, says "it's not up to the state to decide what banks pay their employees or managers." But like other issues on the table in Pittsburgh, this is a battle bankers are likely to lose. In a speech on Wall Street on Sept. 14, the anniversary of the failure of Lehman Brothers, President Barack Obama warned the banking industry not to fight reform. "We will not go back to the days of reckless behavior and unchecked excess at the heart of this crisis, where too many were motivated only by the appetite for quick kills and bloated bonuses," Obama said. The question is just how far G-20 leaders are prepared to go as they balance public rage with the need to keep their financial sectors vibrant.

See the financial crisis blame game.