Daniel K Tarullo: Shared responsibility for the regulation of international
banks
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the18th Annual International Banking Conference "The Future of Large and
Internationally Active Banks", sponsored by the Federal Reserve Bank of Chicago and the
World Bank, Chicago, Illinois, 5 November 2015.
* * *
The regulation of financial institutions is necessarily a dynamic exercise. Growth or
innovations in banking may create new risks that prompt regulatory change. The new
requirements, in turn, incentivize or disincentivize certain actions by financial institutions,
including shifts in activity that may start anew the process of regulatory response. The
regulation of international banking reflects this general pattern, but because internationally
active banks can quickly transmit financial problems across national boundaries, it also
features the question of who should be doing the regulating in a dynamic financial
environment.
Following the financial crisis, during which some internationally active banks posed special
problems for both home and host countries, this issue has commanded attention reminiscent
of the aftermaths of the Herstatt failure of the 1970s and the Bank of Commerce and Credit
International (BCCI) failure of the early 1990s. Unlike those earlier instances, though, this
renewed prominence of the "who does the regulating" question has accompanied a major
reconsideration of what regulation is appropriate. Today I would like to address both the
"who" and the "what" issues in the regulation of international banking. My theme is hardly an
original one - namely, that in the absence of either a global regulator or completely insular
national banking systems, we must continue to work toward a system of shared
responsibilities to assure both home and host regulators that internationally active banks are
subject to adequate oversight and controls.
I will begin by reviewing briefly the benefits and risks associated with international banking
and then identifying the different models for allocating responsibility for the oversight of
international banks. After noting the shortcomings of the system for regulating internationally
active banks that prevailed before the financial crisis and developments in the intervening
years, I will turn to a consideration of the challenges that remain, with a few suggestions on
how we might make more progress.
Benefits and risks of international banking
It is worth at least briefly reminding ourselves of some of the more salient advantages and
risks associated with cross-border banking as they help inform development of regulatory
options.1
Among the potential advantages are facilitating productive capital flows, diversifying risks
associated with growth in host countries, diversifying the earnings and thus the stability of the
global bank, offering counter-cyclical lending through support from the parent when host
country economic conditions constrain domestic banking operations, enhancing efficiency in
financial intermediation in host countries, providing specialized financial services,2 and
providing price or product competition for banking services in host countries. The magnitude
of these benefits obviously differs from country to country, depending on a variety of factors.
Some of these benefits can be greater if foreign banks have the freedom to deploy capital
and liquidity to whatever markets offer the most attractive opportunities, whereas others are
achievable simply through the bank's expertise, existing business relationships, and range of
services.
On the other side of the ledger are the risks associated with foreign banking that are distinct
from risks associated with banking more generally. These risks tend to be related to the
parent bank's capacity to support the larger organization. Reversals in the home market or
other significant foreign operations may reduce the ability of the parent to support its foreign
affiliates with needed capital and liquidity. Even if the foreign affiliate is not itself under great
stress, the weakened overall condition of the parent because of problems in other parts of
the world may prompt it to retrench - often rather abruptly - by reducing activity in foreign
markets in which it is active. This response may be driven either by bank management itself
or at the instance of home country officials who want the bank to continue to lend in its home
market. Especially in countries where foreign banks account for a significant part of financial
intermediation and where the underlying problems are not idiosyncratic to a specific bank,
the result may be a significant diminution in intermediation beyond what would have taken
place because of macroeconomic developments.
Even more serious is the risk that the foreign bank will fail, and that the home country will
lack the resources or the will to ensure either that it is recapitalized and continues to function
or that it fails in an orderly fashion. If the foreign operation has been thinly capitalized and is
lacking in liquidity, host country officials may face an unpleasant choice between supporting
a foreign bank (including operations for which they have not had consolidated supervisory
responsibility) or allowing it to fail in a disorderly fashion, with potentially serious knock-on
effects in the host country's financial system.
Thus, what might have been economic advantages for host countries from foreign banks in
reasonably good times can turn into substantial disadvantages in periods of idiosyncratic or
generalized stress. As with the benefits of foreign banking, the risks vary considerably
among host countries. Obviously, countries without well-developed domestic banking
systems will both benefit more and be at greater risk. Yet even the most sophisticated
domestic financial systems can be affected significantly. For example, the risks can be
exacerbated by funding patterns and currency mismatches, as happened in the United
States during the financial crisis. Foreign banks that had been using their U.S. branches to
raise dollars in short-term markets for lending around the world were suddenly left without
access to this funding and, as a result, made substantial and - relative to their assets -
disproportionate use of the Federal Reserve's discount window.
Approaches to the regulation of internationally active banks
As I mentioned at the outset, international banking raises the question of who should do the
regulating, as well as the question of what regulation is appropriate. The two questions are
related, of course. As I will explain shortly, the nature of regulations in part depends upon the
perspective and aims of the regulator. There are essentially four models, each of which has
benefits and shortcomings.
First, the home jurisdiction can have dominant or exclusive regulatory responsibility for all of
its banks' global operations through application of consolidated regulation and supervision.
Second, host jurisdictions can have dominant regulatory responsibility for all foreign banking
operations within their borders. This approach requires foreign banks to charter locally and to
meet the same regulatory and supervisory standards applicable to domestic banks. Third,
there can be shared authority between home and host jurisdictions, whereby host countries
do some regulating and supervising of foreign banks within their borders but do not require
all foreign banking activities to be locally chartered and subject to regulation identical to that
of home banks. Finally, there could be one global regulator to oversee all the operations of
internationally active banks around the world.
There is an almost unlimited number of variations on the shared approach and, in fact, one
or another variants on that approach have been adopted by most jurisdictions during the
modern banking era (though there have been instances of countries severely limiting or
prohibiting foreign banking altogether). Before turning to a discussion of how the shared
approach has evolved and may be further modified, I think it useful to identify both the appeal
and the problems with the other three, conceptually purer, approaches.
Both the attraction and limitations of the host country model are fairly apparent. On the one
hand, the host country is most likely to be attentive to the risks posed to its financial system
by foreign banks. More generally, the host jurisdiction is at least presumptively best
positioned to craft a regulatory and supervisory framework to protect its financial system from
the particular risks engendered by economic and financial conditions. Having all foreign
banking operations meet local capital and other standards helps achieve that end. The risks
of abrupt shifts of capital and liquidity out of the country can be minimized, and depositors
can be better protected.
On the other hand, a fully local regulatory system would make the costs of entry very high.
For example, if no foreign branches were allowed, or were required to operate as if they were
separately chartered and capitalized, the commitment of resources needed to enter a foreign
market would be considerably higher than those typically associated with opening a branch.
In addition, even complete local subsidiarization might not protect a foreign banking
operation from suffering some contagion if its parent is under stress. Thus, the quality of
home country regulation may have some bearing even under the host country model.
Not surprisingly, the home country model presents essentially the obverse set of advantages
and limitations. Having a consolidated set of capital requirements and a single supervisor
allows for the quickest deployment of capital and liquidity where it is most in demand, or most
needed to relieve stress, and minimizes compliance costs. However, as has often been
pointed out, the home country regulator will be most responsive to the impact of both
regulation and distress of its banks on its own market. In its regulatory and resolution
activities, it is likely to undervalue the potential risks and costs for host countries. In periods
of stress, the home country regulator, accountable primarily to home country legislators or
government officials, may concentrate on stabilizing its own financial markets and be more
inclined to allow, or even demand, a sharp reduction in activity abroad. The result would, at a
minimum, be an abrupt decrease in intermediation at particularly sensitive times. At worst,
foreign operations could default on obligations and exacerbate financial stress.3
At first glance, it might seem that the home country and global regulatory approaches would
yield similar substantive results, since in each case, there would be consolidated regulation
and supervision. A global regulator, however, would at least in theory take the interests of all
jurisdictions into account in regulating, supervising, and resolving a global bank. Of course,
how to balance those interests - particularly in the face of unanticipated circumstances -
would be a difficult, and almost invariably political, judgment. This reality raises the thorny
issue of the accountability of a global regulator.
The political factor is one of many reasons why jurisdictions are likely to remain unwilling to
cede much authority to global, as opposed to international, financial institutions. Indeed, quite
apart from political considerations, there may be good reasons not to do so. For one, a single
global regulator of internationally active banks would presumably be something close to a
regulatory monopolist, whose policies and practices could be inappropriately uniform across
quite different national markets and slow to adapt to changing conditions. Also, as with
dominant or exclusive reliance on home country consolidated supervision, it seems unlikely
that a global regulator - no matter how well-staffed - would be fully informed on the varieties
of financial risks posed to regulated institutions across national markets.
A limited exception to the general disinclination to cede financial sovereignty, as in various
other areas, lies within the European Union or, more precisely, the euro zone. With the
creation of a Single Supervisory Mechanism (SSM) in the European Central Bank and a
freestanding Single Resolution Mechanism (SRM), there have been important transfers of
authority, though national regulators continue to play a supporting role. Interesting and
important as this regional initiative is, however, the unique European arrangement of shared
sovereignty makes it less a model for the world as a whole than an extension of the single
currency project, responding to some of the difficulties encountered during the financial
crisis.
The shared model and lessons of the crisis
The shortcomings of each conceptually "pure" model explains why some version of a shared
home/host model has prevailed over time. Given the range of variations in this model,
however, it is useful to bear in mind the relative advantages and disadvantages of the
cleaner models in choosing the elements of a specific shared approach. In considering
recent developments, as well as what remains to be done, it is also useful to begin by
recalling the situation that prevailed at the onset of the financial crisis.
In its early years, the Basel Committee on Banking Supervision's work focused on
elaborating the responsibilities of home and host regulators of internationally active banks.
The principle of consolidated supervision was developed in the early 1980s, and reinforced
following the failure of the BCCI in the early 1990s, in an effort to ensure that some
regulatory authority had an overview of a global bank's consolidated assets and liabilities. At
the same time, though, the Basel Committee set out expectations for host country prudential
oversight of foreign banks that would be similar to that for domestic banks.4
The financial crisis painfully demonstrated the inadequacy of both home and host country
regulation. Home country regulators of some large, internationally active banks clearly did
not appreciate the risks those firms were assuming overseas. Host country regulators,
including those in the United States, had not exercised prudential oversight of some foreign
bank activities and had not sufficiently appreciated the risks associated with the funding
models and other activities of some foreign banks that were subject to consolidated
prudential regulation. And there were indeed instances of international bank failures in which
the home country authorities seemed to focus on domestic interests to the possible detriment
of the interests of host countries.5
Of course, regulatory failures were far more pervasive than inattention to the specifically
cross-border activities of banks. The substantive rules governing capital and other
requirements for all banks were woefully inadequate, although the fact that most very large
banks around the world have significant cross-border operations exacerbated the
shortcomings. While banks were growing in size, integrating traditional lending and capital
markets in ever more complicated ways and relying increasingly on vulnerable short-term
wholesale funding models, many regulators around the world were at best failing to keep up
with these changes. At worst, they removed older prudential limitations without substituting
new measures designed to address the new realities of banking. The Basel Committee spent
most of the decade before the crisis dominantly focused on the Basel II framework, which
was intended to reduce somewhat effective regulatory capital levels for large banks in return
for their transition to an internal-models-based approach to capital requirements. This was a
choice made by national regulators, led by those in the United States, and not a byproduct of
the structure of the Basel Committee itself.
Adding the lessons of the 2007-09 financial crisis to those of earlier episodes of financial
stress, I think we can infer some guidelines on host and home responsibilities to help shape
expectations for practice. For host countries, the overarching guideline is that each
jurisdiction should take responsibility for protecting the financial stability of its own markets as
its contribution to achieving global financial stability. The extent of this responsibility
obviously increases with the size and significance of the jurisdiction's financial markets. Thus
the United States and the United Kingdom - which currently have the greatest
concentrations of capital markets activities - have a particular obligation to oversee the local
activities of both domestic and foreign banks that could pose particular risks to financial
stability and are likely to be especially difficult to observe for a home country supervisor less
familiar with those markets.
A corollary of this general guideline is that the scope of host country regulation might
sensibly vary with the size and systemic importance of foreign banks. This notion is
consistent with the principle embodied in the Dodd-Frank Wall Street Reform and Consumer
Protection Act that prudential regulation should be progressively more stringent as banks
pose greater risks to financial stability. As I will discuss in a moment, this principle also lies
behind some of the post-crisis frameworks developed by the Basel Committee and the
Financial Stability Board (FSB).
For home countries, the relatively longstanding principle that regulators should exercise
effective consolidated supervision remains critical, though I would emphasize that the
regulation imposed by home jurisdictions is of equal - if not greater - importance. It is
important to emphasize that this obligation is not a substitute for host country regulation and
supervision of foreign banking organizations. The home jurisdiction regulatory structure must
ensure that the banks are fundamentally safe and sound, and that the parent will generally
be able to support its operations around the world. Here, of course, a major shortcoming of
the pre-crisis regime becomes apparent, in that capital and other regulatory requirements for
internationally active banks were simply not strong enough.
Consolidated supervision must contain the risks to the financial system created by banking
activity that is not fully captured by regulations. It must also ensure that banks do not hide
problems by shifting assets or liabilities around their global operations and, more generally,
that the banks are fundamentally safe and sound so as to forestall possible contagion risk to
foreign operations.
Within these admittedly broad guidelines, there is obviously room for host countries to
balance the benefits and risks presented by foreign banking organizations in a number of
different ways. Their choices will be affected by policy preferences, the characteristics of
their domestic financial systems, and the relative importance of foreign banks in those
systems. The host country choices will also inevitably be affected by how home countries are
carrying out their regulatory and supervisory roles. This consideration includes, of course, not
just regulations that are nominally applicable, but the manner in which those regulations are
enforced.
Branching presents a particularly instructive example of the tension between assuring
financial stability and permitting foreign banking operations that may carry economic benefits.
Because branches are not separately chartered and capitalized, a bank can relatively easily
enter a foreign market by opening a branch, through which it can make loans - often initially
to companies from its home country - using funds from the home bank. Particularly where
(as in the United States) foreign branches are forbidden by local law from accepting retail
deposits, it might seem that there are minimal risks to the host country if the parent bank
(and thus the local branch) fails. However, U.S. experience with foreign branches in the
decade prior to the crisis shows the very real risks that can arise when a branch is used to
raise funds in the host country (in the United States, in dollars) through short-term wholesale
borrowing, and then directs those funds out of the host country for loans or asset purchases
by other parts of the bank. As noted earlier, when short-term funding dried up, many foreign
branches were left seriously short of liquidity and had to turn to the discount window.
A shared feature of the U.S. and European Union regulatory systems for foreign banks is that
branching is permitted without requiring separate capitalization. Many other jurisdictions have
similar policies. Thus opportunities for foreign bank entry and market access are provided. In
the United States, larger branches do have to meet some liquidity requirements, though they
are less restrictive than the standards applicable to domestic banks and intermediate holding
companies. This requirement is an important example of a prudential measure that balances
financial stability and the benefits of international banking. The degree to which we or, I
presume, other jurisdictions will remain comfortable with this balance will depend on two
factors. The first factor is the degree to which local branches are used by foreign banks as
significant sources of unstable funding or for other risky purposes. While this has been a
significant issue in the United States, it is less clear that other jurisdictions face similar risks.
The second is the confidence host jurisdiction regulators have that the parent banks are
subject to effective regulatory and supervisory oversight.
Developments since the crisis
The profound shift in political and policy environments as a result of the financial crisis has
led to considerable strengthening of minimum international standards for internationally
active banks, at both national and international levels. Basel III enhanced the quantity and
quality of capital requirements and introduced, for the first time, quantitative liquidity
standards. Following completion of Basel III, the Basel Committee developed a structure of
slightly misleadingly named capital "surcharges," which requires global systemically
important banks (GSIBs) to maintain higher capital levels.6
The Federal Reserve supported all these measures but was a particularly strong advocate of
the capital surcharges, which established the new principle that some international prudential
standards should be progressively more stringent as the systemic importance of a bank
increases. In meeting its responsibility to promote domestic financial stability, the Federal
Reserve last year followed the lead set by the European Union some years previously and
adopted a regulation requiring subsidiaries of GSIBs engaged in traditional banking as well
as those engaged in capital markets activities be covered by local capital requirements
consistent with Basel III. But neither in the United States nor the European Union do the
GSIB capital surcharges imposed at the consolidated level apply to foreign banking
operations in their jurisdictions.7 So even if the global bank has local capital requirements for
most or all of its foreign operations, the parent still has some flexibility as to where the
additional capital buffer can be maintained. More generally, our requirements for other
prudential regulations applicable to foreign banking organizations (FBOs) are calibrated to
the relative importance of the FBOs in the U.S. financial system. Thus the structure of
surcharges also help to create a good mechanism for balancing host country interests in
assuring financial stability and in realizing the benefits that can come from global banking.
Even with good standards, regulators in host jurisdictions will want assurance that these
standards are being rigorously implemented and enforced. The relative opaqueness of bank
balance sheets makes capital, liquidity, and other common banking regulations difficult to
monitor effectively. This argues for complementing fairly complex regulation that seeks to
track the often-complex activities of large banks with simpler regulations, such as the
leverage ratio and a standardized risk-weighted capital floor. But it also argues for existing
international fora such as the Basel Committee and the FSB to provide effective monitoring
mechanisms. Even with higher standards in place, supervisors in home and host jurisdictions
will still face challenges in assessing cross-jurisdiction vulnerabilities. More regular sharing of
information and assessments among home and key host jurisdictions both formally and
informally should be high on our shared agenda.
At present, both those groups have useful processes for overseeing the implementation of
agreed upon international standards. But they tend to be a bit formalistic, concentrating on
comparing the language of domestic implementation to that of the international standards,
rather than examining whether domestic practice in fact ensures substantive compliance or
gaining a shared understanding of the unique risks in each market.
It would, I believe, be counterproductive to establish in either the Basel Committee or the
FSB the kind of adversarial dispute settlement process associated, for example, with the
World Trade Organization. It is in the interest of all members of those bodies to cooperate in
the shared task of overseeing internationally active banks. Thus, the better approach to
compliance would be one that simultaneously provides regulators with a way to work with
one another and to gain deeper insight into how their counterparts in other jurisdictions are
applying prudential standards.
For example, there has been considerable documentation of the interjurisdictional
divergence in risk weights for similar exposures under the internal models-based capital
approaches of Basel II.8 While the Basel Committee has been working on this issue,9 I
suspect that one of the most effective ways of promoting broadly comparable risk weighting
would be to have technically competent supervisory staff from other jurisdictions participate
with home regulators in the actual bank model validations, oversight, and related supervisory
functions. Similarly, as stress testing becomes a more important global financial stability tool,
it will be useful to have staff experienced in stress testing at home participating in the stress
testing exercises of other jurisdictions. These kinds of interactions, along with the more
traditional device of supervisory colleges, can help foster confidence among host jurisdictions
in both the regulatory and supervisory activities of home country authorities.
Another useful practice for furthering mutual confidence would be a program for regular
contact among the very top officials of key regulators. The original Basel Committee brought
together these officials for what were usually relatively informal meetings. As one of the early
participants in those meetings once told me, the relationships he built with his counterparts
through these regular contacts served everyone well when issues concerning international
banks arose. But with the concentration of the Basel Committee on sometimes highly
technical standards, participation has generally drifted down to the senior staff level. The
FSB was created in part to compensate for this change in the Basel Committee. And the FSB
usually does garner higher levels of participation. However, other features of the FSB - such
as including market regulators and finance ministries in order to provide a broader range of
views on financial stability issues - mean that the FSB cannot serve the original Basel
Committee purpose either. Moreover, even when the right member agencies are
represented, the actual individuals participating may not be the most senior officials in the
supervisory function of those agencies. Finally, the near doubling in size of both the Basel
Committee and the FSB, while again critical for ensuring a representative group to consider
financial stability issues, further complicates the matter.
Thus, while a regular, high-level interaction among all key regulators would be optimal, for
the foreseeable future, we will probably have to live with something less than optimal. Ad hoc
meetings around the fringes of various Basel convocations and bilateral interactions may
have to suffice. In this regard, I note the importance of the creation of the SSM within the
European Central Bank as the supervisor for all larger banks in the euro zone. The Federal
Reserve has already established instructive and productive relationships with the
experienced and committed group of supervisors that have been brought in to lead the SSM.
The limits of shared responsibility
It is important to recognize, though, that even with the best of intentions and actions in home
country regulatory and supervisory regimes, there will be limits to how much responsibility
can appropriately be shared for international banking activities. These limits are most
apparent in the context of the possible insolvency of a major foreign banking organization.10
The work of the FSB in promoting effective resolution regimes around the world and in
seeking an international framework for building the total loss absorbing capacity (TLAC) of
GSIBs are very good examples of cooperative efforts that promote the aim of ensuring that
even the largest banks can fail without either causing financial disorder or requiring injection
of public capital. My expectation is that the FSB's framework for TLAC will incorporate the
principle of an extra buffer of loss absorbing capacity at the consolidated level beyond what
may be required in the aggregate at local levels.11 But the margin may be a little thinner here,
precisely because of the circumstances in which the loss absorption capacity may be
needed.
With respect to going concern prudential requirements such as capital levels, host countries
have a continuing opportunity to observe how home country officials are regulating and
supervising their banks. Particularly if effective monitoring mechanisms are developed, host
countries may become comfortable with limited oversight of some or all domestic operations
of foreign banks. If they see the rigor of home consolidated oversight waning, they will have a
chance to intensify their own supervision. But with the prospect of a failed bank, there will be
no time for such adjustments or, as a practical matter, the capacity to impose new
requirements may become limited by the time the prospect of failure is looming. The
imposition of requirements in the midst of a crisis would in any event likely exacerbate stress.
Even with the best of intentions, today's home country regulators cannot effectively bind their
successors' response to the insolvency of one of their globally important banks when political
and economic pressures are likely to be high.
The gone-concern loss absorbency requirement for FBO intermediate holding companies
proposed by the Federal Reserve Board on October 30 should enhance the prospects for an
orderly firmwide global resolution of an FBO by its home country resolution authority through
increasing confidence that the U.S. operations of the FBO will obtain their appropriate share
of the loss absorbency capacity of the consolidated foreign bank. Past experience suggests
that host supervisors are most likely to ringfence assets when there is doubt that the local
customers and counterparties of foreign banks will be adequately taken into account. Yet if,
for any reason, the home jurisdiction resolution is unsuccessful, the internal long-term debt
will be available to U.S. authorities for orderly resolution and recapitalization of the
intermediate holding companies.
We have calibrated our proposed internal TLAC requirements slightly below our proposed
external TLAC requirements for U.S. GSIBs. This slightly lower calibration for internal TLAC
recalls the difference between local going-concern capital requirements and the GSIB
surcharge, but the gap is somewhat smaller, reflecting the concerns I mentioned a moment
ago. The proposal thus balances support for the preferred resolution strategy of the home
resolution authority of the foreign GSIB with assurance of U.S. financial stability if that
strategy cannot be executed successfully.12
Conclusion
My view of shared responsibility for overseeing international banks emphasizes the
importance of financial stability even as it allows for benefits specific to international banking.
For the reasons I have explained, in the end host countries need to make the judgments on
the tradeoffs between these goals