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Regulators’ games

2014/03/02

Are US regulators corraling their financial system with the latest financial-safety rules for foreign banks as Patrick Welter (Frankfurter Allgemeine Zeitung) and others argued or will their move eventually even pave the way for closer cooperation and a revitalization of the worldwide regime of bank supervision?

On 18 February, the Federal Reserve Board approved a final rule strengthening regulation of large US bank holding companies and foreign banking organizations. From July 2016 onwards, banks with a big US presence will have to form an intermediate holding company over their US subsidiaries which will have to meet capital, stress test and, from 2018 onward, leverage requirements. Furthermore, they “will be required to establish a U.S. risk committee and employ a U.S. chief risk officer to help ensure that the foreign bank understands and manages the risks of its combined U.S. operations.” The aim is to bolster the capital and liquidity positions of the US operations of foreign banks and promote a level playing field in the United States.

Fed governor Daniel K. Tarullo explained: “The requirements applicable to foreign banking organizations with a large U.S. presence are an essential part of regulatory reform in the aftermath of the financial crisis. Beginning in the mid-1990s, the profile of foreign bank operations in the United States changed significantly. Foreign banks became more concentrated, more interconnected, and increasingly reliant on the kind of less stable, short-term wholesale funding that proved so volatile when financial stress developed. Many reoriented their operations toward borrowing large amounts of U.S. dollars, often in demand elsewhere in the world, to provide to their parents abroad. Meanwhile, the mix of FBO activities in the United States shifted decidedly toward capital markets, to the point that in recent years the top 10 broker-dealers in the United States have included either four or five foreign-owned firms.

The consequences of these changes in foreign bank activities were seen dramatically during the crisis, when the funding vulnerabilities of numerous foreign banks and the absence of adequate support from their parents made them disproportionate users [my emphasis] of the emergency facilities established by the Federal Reserve. Yet the United States actually lags some other important financial jurisdictions in assuring that large domestic operations of foreign banking organizations have enough capital and liquidity to help provide stability when stress develops.”

And he added:

“I would suggest that the objections raised by those who say this rule would undermine the gains that come from global capital flows overlook or downplay some important points. First, those gains are most endangered when financial activity contracts rapidly in periods of high stress, which underscores the imperative of sound prudential policies. Second, as we have seen repeatedly, ad hoc ring-fencing becomes more likely precisely in those periods of stress, when it is far more damaging to a vulnerable financial system than a well-conceived set of generally applicable ex ante measures imposed in normal times. Third, the rule before us walks a middle road between the vulnerabilities of the status quo and a complete subsidiarization model by, for example, continuing to permit branching. In sum, I would say that the most important contribution we can make to the global financial system is to ensure the stability of the U.S. financial system.”

 Long overdue

Among those who say that the rule would undermine the gains from global capital flows are financial lobbies such as the Global Financial Markets Association (GFMA) and the Institute of International Bankers (IIB). They fear that the rule could exacerbate, rather than mitigate, financial stability risks, harm the global economy and prompt foreign banks to pull back from the US market.

However, other commentators consider the move long overdue. Mayra Rodríguez Valladares, for example, observed:

“In fact, not only have foreign banks not been required to be sufficiently capitalized to sustain unexpected losses, but also they have been even less capitalized than banks with headquarters in the United States. This means that European banks have been in a position to play regulatory arbitrage and book some of their riskier transactions in the United States.”

Foreign banks benefit from “onshore-offshore” markets in the United States. Take the example of Wilmington, Delaware. As I wrote elsewhere:

Wilmington is the largest city in the US state of Delaware with a population of about 70,000. Wilmington is a tax haven and, among others, home of Taunus Corporation, which up to 2011 was the eighth-largest bank holding company in the United States with assets of just over $380 billion (Simon Johnson). Taunus is a subsidiary of Deutsche Bank which in turn has about 2,000 subsidiaries and special purpose vehicles – 430 of which are registered in Wilmington.”

Lex Deutsche Bank?

Simon Johnson described the worries regarding Deutsche Bank from a US perspective. In November 2011 he wrote that “in the past, U.S. authorities have taken the view that Deutsche Bank had a strong enough balance sheet worldwide that more capital could be provided to its American subsidiary, if needed …

Such a presumption now seems questionable, at best. Earlier this year, Bloomberg News reported that Taunus needed almost $20 billion of additional funds to meet U.S. capital standards, and that Deutsche Bank was trying to declassify Taunus as a bank-holding company to avoid capital requirements entirely. …

All of this raises troubling questions. Have U.S. bank supervisors really satisfied themselves, through onsite inspections, that Deutsche Bank’s risk weights accurately reflect market conditions and the increasing structural weakness of the euro area? Can U.S. regulators document their satisfaction beyond the materials produced for the European Banking Authority, which earlier this year oversaw stress tests that pronounced now-collapsed Dexia as well-capitalized? (Actually, Dexia had stronger capital ratios than Deutsche Bank.)“

As I wrote, Deutsche Bank eventually managed to restructure its US business and circumvent financial regulation and capital requirements shifting those parts of the group which unavoidably require a banking licence into a banking group with modest $58 billion of assets, while the much larger part was transformed to an unregulated securities firm. In its 2012 annual report the bank explained in a footnote to a list of „significant subsidiaries“:

“Taunus Corporation is one of two top-level holding companies for the group’s subsidiaries in the United States. Effective February 1, 2012, Taunus Corporation is no longer a bank holding company under Federal Reserve Board regulations.”

Max Colchester and David Enrich (The Wall Street Journal) commented: “The rules have been subject to years of gamesmanship. In 2011, Deutsche Bank irked federal regulators by saying it would change the status of its main U.S. vehicle, Taunus Corp., so that it was no longer a “bank-holding company” and therefore wouldn’t be subject to the Dodd-Frank provisions. Fed officials subsequently said they would adjust the rules to preclude banks from skirting them.”

The current decision however is not a Lex Deutsche Bank. Reuters published a preliminary Fed list of names of the 17 biggest banks that may need to change their structure under the new rules. Those are (in alphabetical order) Banco Santander, Bank of Montreal, Barclays Plc, BBVA, BNP Paribas, Credit Suisse, Deutsche Bank, HSBC Holdings Plc, Mizuho, MUFG, Natixis, Rabobank, Royal Bank of Canada, Royal Bank of Scotland, Societe Generale, Toronto-Dominion Bank and UBS AG.

As Fed governor Tarullo pointed out, experiences during the 2008 financial crisis played an important role. Citing  Stephanie Armour and Ryan Tracy (The Wall Street Journal): “Many foreign banks sought emergency loans from the Fed during the 2008 financial crisis, and the Fed has questioned whether foreign governments of large international firms would always backstop their banks’ U.S. operations in a crisis.”

Yet again, public attention focused on Deutsche Bank. The Bank claimed that it never had state aid. Observers emphasized that this statement referred to the German state. As Deutsche Bank Risk Alert, a US site, wrote:

“Deutsche Bank … did not receive an equity infusion from the German government. Nor did it receive funds directly from the US Troubled Asset Relief Program (TARP.)

But that doesn’t mean it didn’t accept government rescue money …:

– As one of the largest counterparties of failed insurer AIG, Deutsche Bank received $11.8 billion of the funds used to bail out AIG.

– The Federal Reserve made emergency low-cost funds widely available to foreign as well as US member institutions through its discount window. Deutsche Bank was the second heaviest user of such funds, borrowing more than $2 billion.

– The Federal Reserve also created a program known as the Term Asset-Backed Securities Lending Facility, which allowed banks to use their assets, including troubled or hard-to-value assets, as collateral for short term loans. Deutsche Bank was the largest user of the program, sending the Fed more than $290 billion worth of mortgage securities.”

A step back

The rule comes in reaction to the fact that – despite the existence of an international framework for cooperative supervision and regulation of financial institutions – authorities outside the US long ignored, or tacitly approved of, their banks’ risky foreign activities. European parents didn’t take care of their wayward children, as Mayra Rodríguez Valladares put it, and the proverbial US taxpayer felt he was left with the bill.

Inevitably, the US initiative drew protests from Europe and Asia. There are complaints that the rule will distort competition in favor of US banks and undermine attempts to coordinate supervision at the global level through the Basel Committee brushing aside the fact that a growing awareness of the weaknesses of the Basel approach leaves regulators in countries with major financial centres everywhere with a nagging dissatisfaction.

Actually, the promotion of a “level playing field” in the US is a substantial change in the principles of international bank supervision and regulation which date back to the 1970s:

As I wrote elsewhere (Reszat 2005, chapter 6), it was the emergence of the Euromarkets in the 1960s and early 1970s which first raised the question how to monitor and regulate the growing activities of internationally operating banks: “The traditional approach to financial regulation had been surveillance on a territorial basis. The country in which deposits were held imposed reserve requirements on domestic banks and on branches and subsidiaries of foreign banks. Its authorities monitored bank activities and set the rules for bank business and in case of emergency were prepared to act as lender-of-last resort rescuing banks from illiquidity.”

However, this approach did not work in the case of external markets. Absence of reserve requirements on deposits denied policymakers direct control, and the apparently footloose nature of offshore banking required agreement among all countries where offshore activities might take place for territorial surveillance of banks to be effective.

The Basel Concordat of 1974 laid the foundations for consolidated worldwide supervision. Under the auspices of the Bank for International Settlements (BIS) the financial authorities of major industrial countries chose the domiciliary concept as an alternative to the territorial approach to surveillance. They agreed each country to assume lender-of-last-resort responsibility for its offshore banks with the country in which a bank’s headquarters is domiciled imposing consistent regulation across all its offshore branches and subsidiaries. In 1980, this agreement was complemented by rules requiring banks to consolidate worldwide accounts enabling bank supervisors to monitor and regulate offshore and onshore operations on a consistent basis.

The current Federal Reserve decision is a step back from the domiciliary to the territorial principle. Other regulators might follow. The Bank of England just published a Consultation Paper on its approach to supervising international banks. It sets out a series of requirements for non-EU banks wishing to do business in the UK with a special focus on branches (which are treated differently in the US and the UK). As Harry Wilson (The Telegraph) wrote:

“Branches set up in Britain allow overseas banks to do business in the country without having to meet the more onerous regulatory standards required by the UK financial authorities of full-blown subsidiaries. In contrast to a subsidiary, a branch operation does not have to be a separately capitalised legal entity and continues to be regulated in its country of origin.

Non-UK bank branches based in Britain now manage assets worth about £2.4 trillion, equivalent to 160pc of this country’s GDP. But they have become a source of concern for the Bank of England since the financial crisis, amid fears about the standards being imposed on them by their domestic regulators.”

Tit for tat?

The US decision risks to provoke retaliation. Michael Barnier, European commissioner for the internal market was quoted saying: “We will not be able to accept discriminatory measures which would have the effect of treating European banks worse than U.S. ones.”

The latter refers to the fact that as, for example, Michael Kemmer, head of the Association of German Banks, told the Wall Street Journal the US decision is considered as “a considerable competitive handicap for European banks, as their U.S. competitors aren’t subject to any equivalent requirements in the EU.” Sebastien de Brouwer, head of legal affairs at the European Banking Federation, stressed that the move risks creating a standards gap between the US and Europe which would duplicate reporting requirements and fragment liquidity in international markets. Gina Chon, Camilla Hall and Martin Arnold (The Financial Times) argued that the new rules will put European banks at a disadvantage to their US counterparts, “who can calculate their capital requirements based on their entire global operations while the largest foreign banks will be assessed on their US assets only.” And Douwe Miedema (Reuters) pointed to the Fed’s proposed leverage ratio of 6 percent of assets which is well above the 3 percent global requirement.

There is a danger of increasing protectionism worldwide as a consequence of the US decision and of a regulatory competition which in its variety of demands may become ruinous to the financial sector. Given the still dormant crisis in Europe, the stock market bubbles “of historic proportions” developing in the US and UK (Ha-Joon Chang, The Guardian) and the recent sell-off in emerging markets which “could go from a nasty slump in the market to a problem for the banking systems in these countries [and elsewhere]” (Matt Phillips, Quartz), a trade war in financial services is the last thing the world would need.

Cooperation would be the better alternative, especially as the offence should be undisputed. In the end, however, the game is neither about retaliation nor about securing world financial stability. Eventually, as in every important economic area, this is a fight for competitiveness and growth, for market shares and dominance in a more and more challenging global environment with shrinking business, higher costs, declining margins – and incalculable risks. Finding a balance between national interests and the requirements of a stable and secure international financial system as a major player is changing the rules of the game is the challenge ahead.

The banks will try to keep the burden as small as possible. As the Wall Street Journal put it: “European banks and the Federal Reserve began a chess match over new rules for U.S. units of foreign banks, with overseas firms expected to try and limit the impact and Fed officials vowing to prevent banks from evasion.” The question is to which extent the Fed will tolerate evasive moves.

Another question is how regulators elsewhere will react. Europeans which still seem absorbed with containing the consequences of the unsolved eurocrisis for their banks and, at the same time, shielding taxpayers from further bank bailouts, may consider the US rule – or any rule increasing their banks’ burdens beyond the internationally agreed compromise – as highly unwelcome.

However, as Douwe Miedema wrote: “… even some bankers see benefits in the new rule, given the often-acrimonious past problems when different countries had to save a bank with operations across borders. “It simplifies the U.S. part of the bank structure,” said a second senior investment banker, citing the example of the troubled rescue of Franco-Belgian bank Dexia. “If it’s implemented in a balanced way, it could improve the relationship between the home and host regulator, and strengthen cross-border cooperation in resolution.””

The current US initiative might harden fronts. But it might also pave the way for a revitalization of the dialogue on international bank supervision and regulation.

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