Daniel K Tarullo: Regulation of foreign banking organizations
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the Yale School of Management Leaders Forum, New Haven, Connecticut,
28 November 2012.
* * *
In the aftermath of the financial crisis, regulators around the world continue to
implement reforms designed to limit the incidence and severity of future crises. My subject
today pertains to an area in which reforms have yet to be made - the regulation of the U.S.
operations of large foreign banks.1 Applicable regulation has changed relatively little in the
last decade, despite a significant and rapid transformation of those operations, as foreign
banks moved beyond their traditional lending activities to engage in substantial, and often
complex, capital market activities. The crisis revealed the resulting risks to U.S. financial
stability.
In taking a fresh look at regulation of foreign banks in the United States, I by no means
want to imply that the United States should revoke its welcome to foreign banks. On the
contrary, this reconsideration reflects the important role foreign banks have played. The
presence of foreign banks can bring particular competitive and countercyclical benefits
because foreign banks often expand lending in the United States when U.S. banking firms
labor under common domestic strains. But just as we are adapting our regulatory approach
to U.S. banks, so we need to incorporate important lessons learned from the crisis into our
oversight program for foreign banks.
The question of how best to regulate foreign banks is hardly a new one, either here or
in other countries. Debates over the relative merits of territorial versus global or mutual
recognition approaches, the difficulties in achieving strictly equal terms of competition
between banks with different home regulatory systems, and the degree to which
harmonization of international standards and supervisory consultations can mitigate the
resulting inconsistencies and frictions are all familiar topics to academics, banking lawyers,
and supervisory authorities. While I do not aim to resolve this afternoon the complicated
interaction among these perspectives and considerations, I will try to outline a practical and
reasonable way forward.
To be effective, a new approach must address the vulnerabilities that have been
created by the shift in foreign bank activities, in keeping with sound prudential policy and
congressional mandates in the Dodd-Frank Wall Street Reform and Consumer Protection
Act. At the same time, a modified regulatory system should maintain the principle of national
treatment and allow foreign banks to continue to operate here on an equal competitive
footing, to the benefit of the U.S. banking system and the U.S. economy generally.2
Foreign bank regulation in the United States
Regulating the U.S. operations of foreign banks presents unique challenges. Although
U.S. supervisors have full authority over the local operations of foreign banks, we see only a
portion of a foreign bank's worldwide activities, and regular access to information on its
global activities can be limited. Foreign banks operate under a wide variety of business
models and structures that reflect the legal, regulatory, and business climates in the home
and host jurisdictions in which they operate.
Despite these difficulties, the United States has traditionally accorded foreign banks the
same national treatment as domestic banks, and U.S. regulators generally have allowed
foreign banks to choose among structures that they believe promote maximum efficiency at
the consolidated level. Under the statutory scheme established by Congress, permissible
U.S. structures include cross-border branching and direct and indirect subsidiaries, provided
that they operate in a safe and sound manner.3 U.S. law also allows well-managed and
well-capitalized foreign banks to conduct a wide range of bank and nonbank activities in the
United States under conditions comparable to those applied to U.S. banking organizations.
Still, it is worth noting that even as there has been continuity in this basic policy, U.S.
regulation of foreign banks has evolved over the years in response to changes in the extent
and nature of foreign bank activities. Let me mention two examples.
Before 1978, foreign bank branches in the United States were licensed and regulated
by individual states, with little in the way of federal regulation or restrictions. They were not
subject to the full panoply of limitations on interstate banking, equity investments, or
affiliations with securities firms that were applicable to domestic banks. The rapid growth of
foreign banking in the 1970s, particularly branching, prompted an end to this lighter
regulatory regime.4 The International Banking Act of 1978 gave the Federal Reserve Board
regulatory authority over the domestic operations of foreign banks and significantly equalized
regulatory treatment of foreign and domestic firms.5 Congress maintained this approach of
basic competitive equality in the 1999 Gramm-Leach-Bliley Act.6 That law substantially
removed restrictions on affiliations between commercial banks and other kinds of financial
firms for both domestic and foreign institutions operating in the United States. Moreover, in
light of provisions in Gramm-Leach-Bliley that permitted a foreign bank to be a financial
holding company (FHC), the Federal Reserve announced in 2001 that a bank holding
company (BHC) in the United States that was owned and controlled by a well-capitalized and
well-managed foreign bank generally would not be required to meet the Board's capital
requirements normally applicable to BHCs.7
My second example relates to the massive fraud uncovered at the Bank of Credit and
Commerce International (BCCI) and its subsequent collapse in 1991, which highlighted the
need for more effective supervision of banks operating in multiple countries. The Foreign
3
Cross-border branches of foreign banks operate in the United States as a direct branch of the foreign parent
and are not separately capitalized entities. Federal foreign branches and agencies are authorized by
12 U.S.C. §3102, which recognizes that states may also authorize branches of foreign banks to operate within
their territory. The Board of Governors of the Federal Reserve System must approve all foreign branches and
agencies, whether state or federal (see 12 U.S.C.§3105(d)). A good survey of the considerations for both firms
and policymakers in the choice between subsidiaries and branches for foreign banks is provided in Jonathan
Fiechter, Inci Otker-Robe, Anna Ilyina, Michael Hsu, Andre Santos, and Jay Surti (2011), "Subsidiaries or
Branches: Does One Size Fit All?" Staff Discussion Note 11/04 (Washington: International Monetary Fund,
March 7), www.imf.org/external/pubs/ft/sdn/2011/sdn1104.pdf.
4
Between 1972 and 1977, the number of foreign banking institutions in the United States roughly doubled,
while the total assets of those institutions roughly tripled in absolute terms and doubled as a proportion of all
banking assets in the United States, reaching nearly 13 percent. Henry Terrell and Sydney Key (1977), "The
Growth of Foreign Banking in the United States: An Analytical Survey", in Key Issues in International Banking,
Conference Series No. 18 (Boston: Federal Reserve Bank of Boston, October).
5
Pub. L. No. 95-369, 92 Stat. 607, codified at 12 U.S.C. 3101-3111.
6
Pub. L. No. 106-102, 113 Stat. 1338.
7
Board of Governors of the Federal Reserve System, Division of Banking Supervision and Regulation (2001),
"Application of the Board's Capital Adequacy Guidelines to Bank Holding Companies Owned by Foreign
Banking Organizations", Supervision and Regulation Letter 01-01 (January 5),
www.federalreserve.gov/boarddocs/srletters/2001/sr0101.htm.
Bank Supervision Enhancement Act of 1991 (FBSEA) required foreign banks to receive
approval from the Board before establishing a branch or agency in the United States.8 The
law required the Federal Reserve, in turn, to determine that the foreign bank is subject to
"comprehensive supervision or regulation on a consolidated basis" in its home country before
approving an application either to open a branch or to acquire a U.S. subsidiary bank.
It is further worth noting that changes in U.S. law and regulatory practice affecting
foreign banking organizations have often corresponded to changes in international regulatory
agreements. For example, FBSEA was enacted at the same time as the Basel Committee on
Banking Supervision was working to address the problems revealed by BCCI - an effort that
bore fruit the next year in changes to the so-called Basel Concordat, which established
minimum standards for the supervision of international banking groups.9 Another instance
was the substantial reduction or removal of remaining asset-pledge and asset-maintenance
requirements for most U.S. branches of foreign banks, prompted in part by implementation of
the new international capital standards included in the 1988 Basel Accord.
The shift in foreign bank activities
Although foreign banks expanded steadily in the United States during the 1970s,
1980s, and 1990s, their activities here posed limited risks to overall U.S. financial stability.
Throughout this period, the U.S. operations of foreign banks were largely net recipients of
funding from their parents and generally engaged in traditional lending to home-country and
U.S. clients.10 U.S. branches and agencies of foreign banks held large amounts of cash
during the 1980s and '90s, in part to meet asset-maintenance and asset-pledge
requirements put in place by regulators. Their cash-to-third-party liability ratio from the
mid-1980s through the late 1990s generally ranged between 25 percent and 30 percent.
The U.S. branches and agencies of foreign banks that borrowed from their parents and
lent those funds in the United States ("lending branches") held roughly 60 percent of all
foreign bank branch and agency assets in the United States during the 1980s and '90s.
Commercial and industrial lending continued to account for a large part of foreign bank
branch and agency balance sheets through the 1990s.11
This profile of foreign bank operations in the United States changed in the run-up to the
financial crisis. Reliance on less stable, short-term wholesale funding increased significantly.
Many foreign banks shifted from the "lending branch" model to a "funding branch" model, in
which U.S. branches of foreign banks were borrowing large amounts of U.S. dollars to
upstream to their parents. These "funding branches" went from holding 40 percent of foreign
bank branch assets in the mid-1990s to holding 75 percent of foreign bank branch assets by
2009. Foreign banks 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-U.S. affiliates by the
mid-2000s - more than $700 billion on a net basis by 2008.12
A good bit of this short-term funding was used to finance long-term, U.S.
dollardenominated project and trade finance around the world. There is also evidence that a
significant portion of the dollars raised by European banks in the pre-crisis period ultimately
returned to the United States in the form of investments in U.S. securities. Indeed, the
amount of U.S. dollar-denominated asset-backed securities and other securities held by
Europeans increased significantly between 2003 and 2007, much of it financed by the
short-term, dollar-denominated liabilities of European banks.13 Meanwhile, commercial and
industrial lending originated by U.S. branches and agencies as a share of their third-party
liabilities fell significantly after 2003.14 In contrast, U.S. broker-dealer assets of the top-10
foreign banks increased rapidly during the past 15 years, rising from 13 percent of all foreign
bank third-party assets in 1995 to 50 percent in 2011.15
Lessons from the recent financial crisis
The 2007-2008 financial crisis and the continuing financial stress in Europe have
revealed financial stability risks associated with the foreign banking model as it has evolved
in the United States. To some extent the concerns associated with foreign banking
operations track the more general shortcomings of pre-crisis financial regulation.
Internationally agreed minimum capital levels were too low, the quality standards for required
capital were too weak, the risk weights assigned to certain asset classes did not reflect their
actual risk, and the potential for liquidity strains was seriously underappreciated.
But some risks are more closely tied to the specifically international character of certain
global banks, both here and in some other parts of the world. 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. Actions by home-country
authorities during this period showed that while a foreign bank regulatory regime designed to
accommodate centralized management of capital and liquidity can promote efficiency during
good times, it also increases the chances of ring-fencing by home and host jurisdictions at
the moment of a crisis, as local operations come under severe strain and repayment of local
creditors is called into question. Resolution regimes and powers remain nationally based,
complicating the resolution of firms with large cross-border operations.
The large intra-firm, cross-border flows that grew rapidly in the years leading up to the
crisis also created vulnerabilities. To be fair, the ability to move liquidity freely throughout a
banking group may have provided some financial stability benefits during the crisis by
enabling banks to respond to localized balance-sheet shocks and dysfunctional markets in
some areas (such as the interbank and foreign exchange swap markets) and by transferring
resources from healthier parts of the group. Nevertheless, this model also created a degree
of cross-currency funding risk and heavy reliance on swap markets that proved
destabilizing.16 Moreover, 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.
Although the United States did not suffer a destabilizing failure of foreign banks, many
rode out the crisis only with the help of extraordinary support from home- and host-country
regulators. Following national treatment practice, the Federal Reserve itself provided
substantial discount window access to U.S. branches and the opportunity to participate in the
Primary Dealer Credit Facility to U.S. primary-dealer subsidiaries of foreign banks. Moreover,
the potential for funding disruptions did not disappear with the waning of the global financial
crisis. In 2011, for example, as concerns about the euro zone rose, U.S. money market funds
suddenly pulled back their lending to large euro area banks, reducing lending to these firms
by roughly $200 billion over just four months.17
While there has been some reduction in operations and some change in funding
patterns by foreign banking organizations in the United States since the crisis, particularly by
European firms reacting to euro zone financial stress, the basic circumstances have not
changed.18 The proportion of foreign banking assets to total U.S. banking assets has
remained at about one-fifth since the end of the 1990s. But the concentration and complexity
of those assets have changed noticeably from earlier decades, and have not reversed in
recent years despite the global financial crisis and subsequent events. Ten foreign banks
now account for more than two-thirds of foreign bank third-party assets held in the United
States, up from 40 percent in 1995.19 And while the largest U.S. operations of foreign banks
do not approach the size of our largest domestic financial institutions, it is striking that there
are 23 foreign banks with at least $50 billion in assets in the United States - the threshold
established by the Dodd-Frank Act for special prudential measures for domestic firms -
compared with 25 U.S. firms.20
Most notably, perhaps, five of the top-10 U.S. broker-dealers are owned by foreign
banks. Like their U.S.-owned counterparts, large foreign-owned U.S. broker-dealers were
highly leveraged in the years leading up to the crisis. Their reliance on short-term funding
also increased, with much of the expansion of both U.S.-owned and foreign-owned U.S.
broker-dealer activities attributable to the growth in secured funding markets during the past
15 years.21
Finally, we should note that one of the fundamental elements of the current approach -
our ability, as host supervisors, to rely on the foreign bank to act as a source of strength to its
U.S. operations - has come into question in the wake of the crisis. The likelihood that some
home-country governments of significant international firms will backstop their banks' foreign
operations in a crisis appears to have diminished. It also appears that constraints have been
placed on the ability of the home offices of some large international banks to provide support
to their foreign operations. The motivations behind these actions are not hard to understand
and appreciate, but they do affect the supervisory terrain for host countries such as the
United States.
17
SEC N-MFP Form.
18
The significant funding pressures experienced by a number of European firms in 2011, highlighted by a quiet
run by money market funds and other short-term funders, were mitigated by the liquidity-support measures
undertaken by the European Central Bank. As a result, many of the U.S. operations of these firms are
currently receiving net funding from their parents. A parallel development has been a shift in lending activity
from a number of European firms to non-European firms, even as the total proportion of U.S. lending
accounted for by foreign banks has remained roughly constant in the last few years.
19
FR Y-9C, FFIEC 002, FR 2886b, FFIEC 031/041, FR Y-7N/S, X-17A-5 Part II (SEC Form 1695), and X-17A-5
Part IIA (SEC Form 1696).
20
Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2011).
Sections 165 and 166 apply to all foreign banks with $50 billion or more in global consolidated assets and a
U.S. banking presence of any size. More than 100 foreign banks operating in the United States would meet
this threshold today (source: FR Y-7Q). Whether such a bank with relatively small U.S. operations should be
subject to the same prudential requirements as those with U.S. operations in excess of $50 billion is an open
question.
21
SEC FOCUS reports.
International and domestic regulatory response
Since the crisis, important changes have been made to strengthen international
regulatory standards. The Basel III capital and liquidity frameworks are big improvements,
and the proposed capital surcharges for systemically important firms will be another
important step forward. But these reforms are primarily directed at the consolidated level,
with little attention to vulnerabilities posed by internationally active banks in host markets.
The risks associated with large intra-group funding flows have remained largely
unaddressed. Managing international regulatory initiatives also has become more difficult, as
the number of complex items on the agenda has increased. And despite continued work by
the Financial Stability Board, challenges to cross-border resolution are likely to remain
significant. For the foreseeable future, then, our regulatory system must recognize that while
internationally active banks live globally, they may well die locally.
Quite apart from the need to act pragmatically under the circumstances, it is not clear
that we should aim toward extensive harmonization of national regulatory practices related to
foreign banking organizations. The nature and extent of foreign banking activities vary
substantially across national markets, suggesting that regulatory responses might best vary
as well. For instance, the importance of the U.S. dollar in many international transactions can
motivate foreign banks to use their U.S. operations to raise dollar funding for their
international operations, potentially creating vulnerabilities. Such a model is unlikely to
prevail in most other host financial markets around the world.
Indeed, in response to financial stability risks highlighted during the crisis, ongoing
challenges associated with the resolution of large cross-border firms, and the limitations of
the international reform agenda, several national authorities have already introduced their
own policies to fortify the resources of internationally active banks within their geographic
boundaries. Regulators in the United Kingdom, for example, have recently increased
requirements for liquidity to cover local operations of domestic and foreign banks, set stricter
rules around intra-group exposures of U.K. banks to foreign subsidiaries, and moved to
ring-fence home-country retail operations.22 Meanwhile, Swiss authorities have explicitly
prioritized the domestic systemically important operations of their large, internationally active
firms in resolution.23
Here in the United States, Congress included in the Dodd-Frank Act a number of
changes directed at the financial stability risk posed by foreign banks. Sections 165 and 166
instruct the Federal Reserve to implement enhanced prudential standards for large foreign
banks as well as for large domestic BHCs and nonbank systemically important financial
institutions. Dodd-Frank also bolstered capital requirements for FHCs, including foreign
FHCs, by extending the well-capitalized and well-managed requirements beyond U.S. bank
subsidiaries to the top-tier holding company.
In addition, the so-called Collins Amendment in Dodd-Frank removed the exemption
from BHC capital requirements granted by the Federal Reserve's Supervision and
Regulation Letter 01-01.24 The required phase-out of SR 01-01 was clearly intended to
strengthen the capital regime applied to the U.S. operations of foreign banks; however, the
organizational flexibility that the amendment gave to foreign banks in the United States has
allowed some large foreign banks to restructure their U.S. operations to minimize the impact
of this regulatory change. As a result, in the absence of additional structural requirements for
foreign banks in the United States, the effectiveness of our capital regime for large foreign
banks with both bank and nonbank operations in the United States depends on the foreign
bank's own organizational choices.
A rebalanced approach to foreign bank regulation
As has been the case in the past, we need to adjust the regulatory requirements for
foreign banks in response to changes in the nature of their activities in the United States, the
risks attendant to those changes, and instructions from Congress in new statutory provisions.
The modified regime should counteract the risks posed to U.S. financial stability by the
activities of foreign banking organizations, as manifested in the years leading up to, and
through, the financial crisis. Special attention must be paid to the risk of runs associated with
significant reliance on short-term funding. In addition, the regime should reduce the
difficulties in resolution of cross-border firms. Finally, it should take steps to diminish the
potential need for ex-post ring-fencing when losses mount or runs develop during a crisis,
since such actions may well be unhelpfully procyclical.
At the same time, in modifying our regulatory regime for foreign banking organizations,
we must remain mindful of the benefits that foreign banks can bring to our economy and of
the important policies of national treatment and comparable competitive opportunity. Thus,
we should chart a middle course, not moving to a fully territorial model of foreign bank
regulation, but instead making targeted adjustments to address the risks I have identified. In
basic terms, three such adjustments are desirable.
First, a more uniform structure should be required for the largest U.S. operations of
foreign banks - specifically, that these firms establish a top-tier U.S. intermediate holding
company (IHC) over all U.S. bank and nonbank subsidiaries. An IHC would make application
of enhanced prudential supervision more consistent across foreign banks and reduce the
ability of foreign banks to avoid U.S. consolidated-capital regulations. Because U.S.
branches and agencies are part of the foreign parent bank, they would not be included in the
IHC. However, they would be subject to the activity restrictions applicable to branches and
agencies today as well as to certain additional measures discussed below.
Second, the same capital rules applicable to U.S. BHCs should also apply to U.S.
IHCs. These rules have been reshaped to counteract the risks to the U.S. financial system
revealed by the crisis and should be implemented consistently across all firms that engage in
similar activities. Similarly, other enhanced prudential standards required by the Dodd-Frank
Act - including stress testing requirements, risk management requirements, single
counterparty credit limits, and early remediation requirements - should be applied to the U.S.
operations of large foreign banks in a manner consistent with the Board's domestic
proposal.25
Third, there should be liquidity standards for large U.S. operations of foreign banks.
Standards are needed to increase the liquidity resiliency of these operations during times of
stress and to reduce the threat of destabilizing runs as dollar funding channels dry up and
short-term debt cannot be rolled over. For IHCs, the standards should be broadly consistent
with the standards the Federal Reserve has proposed for large domestic BHCs, pending final
adoption and phase-in of quantitative liquidity requirements by the Basel Committee.26 That
is, they should be designed to ensure that, in stressed circumstances, the U.S. operations
have enough high-quality liquid assets to meet expected net outflows in the short term. There
should also be liquidity standards for foreign bank branch and agency networks in the United
States, although they may be less stringent, in recognition of the integration of branches and
agencies into the global bank as a whole.
By imposing a more standardized regulatory structure on the U.S. operations of foreign
banks, we can ensure that enhanced prudential standards are applied consistently across
foreign banks and in comparable ways between U.S. banking organizations and foreign
banking organizations. As with domestic firms subject to enhanced prudential standards, the
Federal Reserve would work to ensure that the new regime is minimally disruptive, through
transition periods and other means.
An IHC structure would also provide the Federal Reserve, as umbrella supervisor of
the U.S. operations of foreign banks, with a uniform platform to implement a consistent
supervisory program across large foreign banks. In the case of foreign banks with the largest
U.S. operations, the IHC would also help mitigate resolution difficulties by providing U.S.
regulators with one consolidated U.S. legal entity to place into receivership under title II of
the Dodd-Frank Act if the failure of the foreign bank would threaten U.S. financial stability.
Branches and agencies would remain separate, but all other entities would be included.
Further, an IHC structure would facilitate a consistent U.S. capital regime for bank and
nonbank activities of foreign banks under the IHC, similar to the approach taken in other
jurisdictions, such as the United Kingdom and some continental European countries.
Some observers will, I am sure, ask if it is necessary to depart from the prevailing
firmby-firm approach to foreign banking regulation and to adopt generally applicable
requirements in implementing the Dodd-Frank enhanced prudential standards for foreign
banks. It is difficult to see how reliance on this approach can be effective in addressing risks
to U.S. financial stability, at least in the absence of extraterritorial application of our own
standards and supervision, and perhaps not even then. We would, at a minimum, need to
make regular and detailed assessments of each firm's home-country regulatory and
resolution regimes, the financial stability risk posed by each firm in the United States, and the
financial condition of the consolidated banking organization. In fact, such an approach might
result in the worst of both worlds - an ongoing intrusiveness into the consolidated
supervision of foreign banks by their home-country regulators without the ultimate ability to
evaluate those banks comprehensively or to direct changes in a parent bank's practices
necessary to mitigate risks in the United States. 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 U.S operations as extensive as those of many large U.S. institutions.
It is also important to note that while the reforms I have described today contain some
elements that are more territorial than our current approach, including requiring some
additional capital and liquidity buffers to be held in the United States, they do not represent a
complete departure from prior practice. This enhanced approach would allow foreign banks
to continue to operate branches in the United States and would generally allow branches to
meet comparable capital requirements at the consolidated level. Similarly, this approach
would not impose a cap on intra-group flows, thereby allowing foreign banks in sound
financial condition to continue to obtain U.S. dollar funding for their global operations through
their U.S. entities. It would instead provide an incentive to term out at least some of this
funding in a way that reduces the risk of runs.
Requiring additional local capital and liquidity buffers, like any prudential regulation,
may incrementally increase cost and reduce flexibility of internationally active banks that
manage their capital and liquidity on a centralized basis. However, managing liquidity and
capital on a local basis can have benefits not just for financial stability generally, but also for
firms themselves. During the crisis, the more decentralized global banks relied somewhat
less on cross-currency funding and were less exposed to disruptions in international
wholesale funding and foreign exchange swap markets than the more centralized banks.27
Indeed, as noted earlier, in the wake of the crisis and of subsequent stresses, many foreign
banks have modified their funding practices and business models. In revamping our
approach, we will both be guarding against a return to pre-crisis practices and, more
generally, ensuring that foreign banking operations in the United States that pose potential
risks to U.S. financial stability are regulated similarly to domestic banking operations posing
similar risks.
Conclusion
The imperative for change in our foreign bank regulation is clear and, indeed,
mandated by Dodd-Frank. Of course, I have provided only an outline of the three key
measures that will best navigate the middle course I have suggested. The all-important
details are under discussion at the Board. I anticipate that in the coming weeks we will
complete our work and issue a notice of proposed rulemaking that will elaborate the basic
approach I have foreshadowed. I look forward to hearing your general reactions today and
more specific feedback after the Board has adopted a proposed rule.