March 22, 2019

High & Low Finance: Foreign Banks in U.S. Face Greater Restrictions

Those days are gone. Despite a lot of talk about the need for international cooperation in regulation, it now appears that American regulators intend to assure that foreign banks operating in the United States have adequate capitalization.

It was not always such. Until the financial crisis, the Federal Reserve was happy to allow American subsidiaries of foreign banks to have no capital at all, and some did not. At the end of 2007, Deutsche Bank’s American operations reported having a negative $8.8 billion in capital.

How could any regulator allow that? The idea was that the presumably well-capitalized parent back home would stand behind the American operation if it ran into trouble. And the United States could, of course, rely on home countries to both regulate their banks and, if something went badly wrong anyway, provide bailouts.

But as the crisis approached, some funny things were happening. Until the turn of the century, American operations of foreign banks tended to receive financing from home. But as the credit party grew after 2003, those banks increasingly borrowed in America’s short-term markets and sent the money back home to the parent.

When the credit crisis appeared, that financing — a significant part of which had come from selling short-term securities to United States money market funds — dried up.

“Foreign banks that relied heavily on short-term U.S. dollar liabilities were forced to sell U.S. dollar assets and reduce lending rapidly when that funding source evaporated, thereby compounding risks to U.S. financial stability,” Daniel K. Tarullo, a Fed governor, said in a speech late last year.

The foreign banks ended up needing a disproportionate share of loans the Fed handed out to stabilize banks. And since then the ability, let alone the willingness, of some countries, particularly in Europe, to provide what the Fed delicately calls “backstops” — a term that sounds much less harsh than “bailouts” — appears to have diminished.

In December, the Fed proposed new rules that have set off loud protests from overseas and are likely to provoke a flood of complaints before the comment period ends on Tuesday.

The rules would require that American subsidiaries of each foreign bank be put together in a holding company that would have to maintain capital, and liquidity, in the United States. In some cases the requirements would be greater than home countries require of the parent institutions.

In a letter to the Fed, Michel Barnier, the European commissioner in charge of internal markets, complained that the proposal was “a radical departure” from internationally accepted policies. He darkly warned that if the Fed did not back down and accept that Europe will do a perfectly good job of regulating its own banks, the new rules “could spark a protectionist reaction” from other countries and bring on “a fragmentation of global banking markets and regulatory frameworks.”

The proposed rules seem to be particularly objectionable to some European banks in two ways. The first is the introduction of an effective 5 percent leverage ratio — calculated as the equity capital of the operation divided by the total amount of assets.

To banks with a lot of securities market activities, that sounds like a harsh rule. Deutsche Bank is particularly upset.

Some other European banks seem to be worried by the application of rules requiring an adequate level of very liquid assets relative to the bank’s short-term financing. The idea there is that if the short-term financing dries up again, the bank will be able to cope for at least a brief period without having to either conduct a fire sale of assets or turn to the Fed for help.

These rules might not actually require the banks to raise a lot of cash, or invest a lot of money in low-returning assets. To meet the liquidity rules, a bank could add more superliquid securities, like United States Treasury or agency securities. Or it could change its financing. Rather than borrowing huge sums overnight, it could borrow at longer maturities, perhaps 45 days. Then it would not need as many liquid assets.

Floyd Norris comments on finance and the economy at

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