Successive US administrations have always allowed well-managed and well-capitalized foreign banks to operate in the US under conditions comparable to those applied to domestic banking organizations. The 1999 Gramm-Leach-Bliley Act allowed subsidiaries of foreign-owned banks to register as bank holding companies (BHCs), and this has been the typical corporate structure adopted by large multinational banks operating in the US: the foreign-owned domestic US banks – and any other operations – are owned through an intermediate BHC.
These foreign banking organizations (FBOs) now account for a substantial proportion of US financial business. A number of factors drive this: the status of the dollar as a quasi-global reserve currency; the fact that many commodities and assets, from gold to oil, are denominated in dollars; and the willingness of foreign investors to finance the US government’s US$1.3 trillion budget deficit. According to the Institute of International Bankers (IIB), their members’ US operations have approximately US$5 trillion in assets and fund 25 percent of all commercial and industrial bank loans made in the US. US broker-dealer subsidiaries of foreign banks account for nearly one-third of all US dollar denominated securities underwriting. FBOs make a critical contribution to the US Treasury repo market, constituting a majority of the primary dealers.1 Crucially, the US administration historically took the view that where the parent company was subject to standards of regulatory oversight and control in its own country which were comparable to those of the US itself, it would not also have to meet US capital requirements in relation to the BHC. This exemption was made explicit by the Federal Reserve in 2001.2 Underpinning this policy was a philosophy of trust and cooperation between regulators in the major economies, and mutual recognition of the broad equivalence of domestic prudential standards.
Crisis and response
Among many in the US administration, confidence in this approach was seriously shaken by the financial crisis. As Daniel Tarullo, a Governor of the Federal Reserve, claimed: “The location of capital and liquidity proved critical in the resolution of some firms that failed during the financial crisis. Capital and liquidity were in some cases trapped at the home entity, as in the case of the Icelandic banks and, in our own country, Lehman Brothers."3 This raised the spectre of ‘ring-fencing’ by local jurisdictions which would prevent US creditors recovering their capital. Sheila Bair, former chairman of the Federal Deposit Insurance Corporation, said, “When an institution becomes stressed, long experience has shown that foreign banks and their regulators are reluctant to send capital abroad to support US operations."4
In response, the Dodd-Frank Act5 withdrew the exemption from BHC capital requirements for foreign-owned banks: as from 2015, they would have to hold regulatory capital in their US subsidiaries in the same way as domestic US banks. From a US perspective, this could be presented as establishing a level playing field, and applying the same standards to foreign as to US banks; for the former, however, it threatened to impose substantially higher costs on their US operations, reduce capital flexibility and potentially expose them to more stringent capital requirements overall, once the interaction with Basel III was taken into account.
In their turn, the major global banks operating in the US considered how to respond. The first to move was Barclays, which in November 2010 deregistered Barclays Group US from BHC status, restructuring its operations so that they were no longer subject to the new regulations. Deutsche Bank followed suit in March 2012, moving Deutsche Bank Trust Corp out of its BHC to become a direct subsidiary. The move was reported to save DB up to US$20 billion in additional capital avoided.6
Raising the stakes
In turn again, US regulators have moved to head off such avoiding action. In a major speech in November 2012,7 Daniel Tarullo proposed that the largest US operations of foreign banks should be required to establish a top-tier US intermediate holding company (IHC) over all its US bank and non-bank subsidiaries; and that the same capital rules should apply to these as to US BHCs. They would also be subject to liquidity requirements (as would US branches of FBOs) to ensure that they had sufficient high-quality liquid assets to meet expected net outflows in the event of a crisis in their US-based operations.
Justifying these proposals, Tarullo pointed to a major qualitative shift in the nature of foreign banks’ operations in the US which had taken place since the late 1990s. Historically, these subsidiaries borrowed from their international parents and lent into the US market. However, this pattern began to reverse substantially in the run-up to the crisis. Many foreign-owned banks began borrowing dollars from their US subsidiaries to finance their global (dollar) operations: Tarullo claimed:
“Foreign banks [in the US] as a group moved from a position of receiving funding from their parents on a net basis in 1999 to providing significant funding to non-US affiliates by the mid-2000s – more than US$700 billion on a net basis by 2008.”
As a consequence, he argued, the US has become increasingly vulnerable since the crisis to the danger that US depositors’ capital would be trapped overseas in the event of a further crisis. In Tarullo’s view, “Although the Federal Reserve will continue to cooperate with its foreign counterparts in overseeing large, multinational banking operations, that supervisory tool cannot provide complete protection against risks engendered by US operations as extensive as those of many large US institutions.” It is this risk to financial stability in the US which is now the driving force of US regulatory policy.
International concern is growing over the Federal Reserve’s actions, and at the potential for unilateral protectionism it may represent.
Michel Barnier, the current European Commissioner for Internal Market and Services, wrote in April 2013 to Ben Bernanke, Chairman of the Federal Reserve, expressing his concern.8 He reiterated the G20 position – which the US fully endorsed at the time – that the global nature of financial markets and the lessons drawn from the recent crisis clearly call for a globally-coordinated response. He pointed out that the Federal Reserve’s current proposals: “seem to be in substantial contradiction to the global regulatory convergence and could have a negative impact on the implementation of Basel II, jeopardizing and/or delaying the process.”
He warned that the US action could spark a protectionist reaction from other jurisdictions, and severely damage economic recovery. If the European Union retaliated by imposing similar requirements on local subsidiaries of US banks, the financial impact would be substantial.
At the same time, the IIB forwarded a detailed critique of the US proposals to the Governors of the Federal Reserve.9 This argued that the proposed regulations raised fundamental concerns. In particular, they failed to reflect Congress’s explicit direction to take into account the extent to which an FBO is subject on a consolidated basis to home country standards that are comparable to those applied in the US.10
In addition, the potential market impact could be profound. The significant, and growing, presence of foreign bank operations in the US is a double-edged sword. It may increase domestic risk – although this is unproven. Equally, it implies an increasingly significant contribution of FBOs to US capital markets which would be threatened if significant numbers of banks decided to curtail or withdraw from their US business.
The IIB argued that the proposed regulations would be “virtually certain to discourage many FBOs from committing to US financial markets”. There were also serious concerns about the potential impact on the depth and liquidity of the US Treasury repo market – which is expensive on capital; FBO-owned primary dealers could withdraw from the market or scale back their US operations, adversely affecting pricing.
Turning to the wider potential impact on global economic recovery, the IIB argued:
“…profound changes to current US supervisory and regulatory practices should be undertaken only with extreme care and after careful study of its (sic) implications for cross-border banking and US financial markets. This observation becomes even more important in light of the risk that other countries will adopt reciprocal measures in response to the Board’s Proposal.”
Additional serious concerns have been raised by the European Banking Federation – which has suggested that the reforms are illegal under both US banking law and WTO law; by Christian Noyer, Governor of the Banque de France; and by Jonathan Faull, DG Internal Market and Services, responsible for financial regulation.
The overall global approach to regulatory reform, mandated by the G20 and explicitly endorsed by the US, depends on coordinated and reciprocal action. Unilateral action – by the US or by any other country – in defiance of considered international concern, could trigger a slide into domestic protectionism and regulatory competition, damaging financial stability and international trade.
The developing controversy could have significant implications for the agreement of recovery and resolution plans (RRP) for global systemically important financial institutions. Key to these plans is the creation of ‘bail-in’ (enforced re-capitalization) or comparable resolution mechanisms to be triggered in case of failure. Broadly, there are two possible approaches:
- single point of entry (SPE), where the ‘home’ regulator of the group imposes resolution measures at the top of a global group;
- multiple point of entry (MPE), where resolution measures are applied by a number of domestic authorities to multiple companies in the group.
The Bank of England has commented that which strategy is more appropriate will depend on the structure of the group: “For an SPE resolution to be appropriate, loss-absorbing instruments must have been issued at the top of the group and be available to cover losses in the group’s subsidiaries… For MPE to be appropriate, it needs to be feasible to separate the group financially, operationally and legally along national or regional lines.”11
The US Federal Deposit Insurance Corporation (FDIC) has argued in favor of a single point of entry. However, this is incompatible with the capital ring-fencing position currently taken by the Federal Reserve. The independent observer may reasonably feel that the right hand of the US administration does not know what the left hand is doing. And it is rather disappointing that, despite the public statements of the G20 and the efforts of the Financial Stability Board to put more effective regulatory frameworks in place, this issue seems to highlight a growing lack of trust between national authorities.
Before pressing ahead regardless, the US administration needs to consider four key questions:
- If the FBOs pull back from providing credit to the US market, is there sufficient capacity and appetite among domestic players to fill the gap?
- If the FBOs pull back from the repo market, what would this do the US bond market? And what might be the implications for the US government’s ability to raise debt effectively and maintain an efficient, liquid and orderly market?
- Is the US prepared to see global trade – which is still dominated and priced to a greater extent in US dollars – distorted in the short term, or in the long term move away from the dollar? What might be the implications for world trade and also for the US’s political influence in the world?
- What conclusions should be drawn about the attitude of the US to corporate governance and respect for national laws if shareholders in FBO parent companies lose a significant degree of control over their US assets? Policy-makers claim to want shareholders to become more engaged in companies they invest in, but the proposed rules seem not to acknowledge this.
If the principles which have historically underpinned cross-border financial supervision are seriously undermined, the consequences could be profound indeed.
1 Comment Letter from the Institute of International Bankers to the Governors of the Federal Reserve, 30 April 2013
2 “Application of the Board’s Capital Adequacy Guidelines to Bank Holding Companies Owned by Foreign Banking Organizations,” Supervision and Regulation Letter 01-01 (5 January 2001)
3 Daniel Tarullo, “Regulation of Foreign Banking Organizations”, Speech to the Yale School of Management Leaders Forum, New Haven Connecticut, 28 November 2012
4 Quoted in Deutsche Bank avoids US capital rules, Financial Times, 21 March 2012
5 Specifically, the “Collins Amendment” incorporated into s171, Leverage and Risk-Based Capital Requirements.
6 Wall Street Journal, 13 April 2011
8 Michel Barnier, letter to Ben Bernanke, 23 April 2013
10 The reference is to Dodd-Frank § 165(b)(2)
11 Written evidence from the Bank of England, Parliamentary Commission on Banking Standards, Resolution and Ring Fencing: Changes to the statutory regime for resolution, 20 November 2012