Federal Reserve Governor Daniel Tarullo gave a speech discussing what he termed a “practical and reasonable way forward” in the U.S. regulation of foreign banking organizations. Tarullo noted that the profile of foreign bank operations in the United States changed significantly in the run-up to the financial crisis (see also attached study), shifting from a “lending branch” model to a “funding branch” model, in which U.S. branches of foreign banks began borrowing large amounts of U.S. dollars “to upstream to their parents.” The financial crisis, Tarullo argued, has served to reveal the financial stability risks associated with the foreign banking model as it has evolved in the United States. One of these dangers, Tarullo noted, is that a global bank’s capital and liquidity can end up “trapped at the home entity” in the event of a failure.
Tarullo stated that as a result of the changes in the activities of foreign banks and the risks attendant to those changes, regulators will need to adjust the regimes applicable to foreign banks. In particular, Tarullo outlined the following prospective changes:
- A “more uniform structure” for the largest U.S. operations of foreign banks, which would require that they establish a top-tier U.S. intermediate holding company (an “IHC”) over all U.S. bank and non-bank subsidiaries. Tarullo argued that this would allow for more consistent supervision across foreign banks, and would also reduce the ability of foreign banks to avoid U.S. consolidated-capital regulations.
- The same capital rules applicable to U.S. BHCs should also apply to U.S. IHCs.
- There should be liquidity standards for large U.S. operations of foreign banks. For IHCs, the standards would be “broadly consistent with the standards the Federal Reserve has proposed for large domestic BHCs.”
Tarullo noted that the Fed expects to issue a notice of proposed rulemaking in line with the basic approach outlined above “in the coming weeks.”
Lofchie Comment: Governor Tarullo suggests a radical change in the manner in which the U.S. operations of non-U.S. banks are regulated from (i) our current regime in which U.S. bank regulators largely defer to home country regulators to (ii) a new regime in which the U.S. regulators would assume a substantial degree of control over the U.S. operations of non-U.S. banks, including potentially requiring non-U.S. banks having bank and corporate subsidiaries in the United States to be part of a separate mid-tier subsidiary referred to as an IHC. Essentially, the IHC would be regulated as a U.S. bank holding company. The U.S. branches of non-U.S. banks would also be subject to additional regulation, although perhaps not as great as that applicable to separate subsidiaries.
Governor Tarullo provides a number of reasons as to why such a shift in U.S. policy is required including the following: (i) non-U.S. banks have become net borrowers in the United States, rather than net lenders to the United States (see footnote 12 of the speech); (ii) during the financial crisis, non-U.S. banks were directly supported by the Fed (as well as their home country regulators); (iii) in a future financial crisis, Governor Tarullo believes that non-U.S. governments may be less willing or able to support the U.S. branches of their home country banks, thus increasing their potential need for support from the Fed or the potential that their failure disrupts the U.S. economy; and (iv) non-U.S. banking organizations play a major role in the U.S. banking and securities markets (23 foreign banks with $50 billion in assets in the U.S. as compared to 25 U.S. banking organizations of such size in the United States; likewise, five of the top ten securities firms in the United States are subsidiaries of non-U.S. organizations).
I do not know whether the legislative and regulatory changes suggested by Governor Tarullo are on the same scale in their impact as those mandated by Dodd-Frank; if they are not, they are not far off. He is suggesting a very substantial re-thinking of the manner in which global financial institutions are regulated, so that host country regulation is emphasized over home country regulation.
To return to the comparison with Dodd-Frank, this proposal would also entail, I think, some substantial re-thinking of portions of Dodd-Frank, such as Lincoln and Volcker, insofar as they apply to non-U.S. banks.