Daniel K Tarullo: Regulating large foreign banking organizations
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the Harvard Law School Symposium on "Building the Financial System of the
Twenty-first Century: An Agenda for Europe and the United States", Armonk, New York,
27 March 2014.
* * *
The financial crisis exposed, in painful and dramatic fashion, the shortcomings of existing
regulatory and supervisory regimes. In both the United States and the European Union (EU),
the crisis also revealed some particular vulnerabilities created by foreign banking operations.
This evening I would like to focus on these vulnerabilities and on how best we should
address them.
Let me note at the outset the now commonplace observation that we have a quite integrated
international financial system, with many large, globally active firms operating within a
system of national government and regulation or, in the case of the EU, a hybrid of regional
and national regulation. I add the equally commonplace observation that there is no realistic
prospect for having a global banking regulator and, consequently, the responsibility and
authority for financial stability will continue to rest with national or regional authorities.1 The
question, then, is how responsibility for oversight of these large firms can be most effectively
shared among regulators. This, of course, is the important issue underlying the perennial
challenge of home-host supervisory relations.
Another introductory observation is that - at least in a world of nations with substantially
different economic circumstances, different currencies, and banking and capital markets of
quite different levels of depth and development - there will be good reason to vary at least
some forms of regulation across countries. Presumptively, at least, nations should be able to
adjust their regulatory systems based on local circumstances and their relative level of risk
aversion as it pertains to the potential for financial instability. Although the financial systems
and economies of the United States and the EU are more similar to one another than they
are to those of many other jurisdictions, they are hardly identical. Even between these two,
for example, there may be legitimate differences within the broader convergence around
minimum regulatory and supervisory standards developed at the Basel Committee, the
International Organization of Securities Commissions, the Financial Stability Board, and
other forums.
These opening observations are important in responding to the curious charge of
"Balkanization" that has been levelled at the United States and, to a lesser extent, some
other jurisdictions, as a result of actions taken or proposed in response to problems
presented by foreign banks during the crisis. I say "curious" for several reasons. One is that
the charge reflects a misunderstanding of the allocation of responsibility between home and
host supervisors that has evolved in the Basel Committee during the past several decades.
Another is that the charge seems implicitly, and oddly, premised on the notion that what we
had in 2007 was a well-functioning, integrated global financial system with effective
consolidated supervision of global banks. A third is that the charge overlooks the fact that
much of what the United States is now doing is matching what the EU has quite sensibly
been doing for years.
In the rest of my remarks I will elaborate on these points, though not in the spirit of a
debater's arguments, but in an effort to answer the question I posed a moment ago: How,
that is, can we successfully reduce the risks to financial stability posed by large,
internationally active banks? As I hope will become apparent, a theme I wish to emphasize is
that we need to redouble efforts at genuine supervisory cooperation if we are to manage
effectively the vulnerabilities and challenges posed by the perennial home-host issue.
International principles on home- and host-country responsibilities
While the circumstances and risks may have changed, the issue of the appropriate roles of
home and host countries is not a new one. Indeed, it was a key motivation for creation of the
Basel Committee in 1975 following the failures of the Herstatt and Franklin National banks.
Many of the Basel Committee's early activities were focused on the challenges created by
gaps in the supervision of internationally active banks, as evidenced by the fact that Basel
"Concordats" on supervision preceded Basel "Accords" and "Frameworks" on capital and
other subjects. This task has, of necessity, been ongoing, as experience revealed gaps in
supervisory coverage and as the scale and scope of internationally active banks grew. The
principle of consolidated supervision emerged in the early 1980s to ensure that some specific
banking authority - generally the home-country regulator - had a complete view of the
assets and liabilities of the bank.2 This principle was reinforced and elaborated following the
Bank of Credit and Commerce International episode in the early 1990s.3
It is important to note that each Basel Committee declaration on the importance of
homecountry consolidated oversight has also included a statement of the obligations and
prerogatives of host states in which significant foreign bank operations are located. This
feature of the Basel Committee's approach makes sense as a reflection both of the host
authority's responsibility for stability of its financial system and of the practical point that a
host authority will be more familiar with the characteristics and risks in its market. In
accordance with this history, the current version of the "Core Principles for Effective Banking
Supervision" sets out as one of its "essential criteria" for home-host relationships that "[t]he
host supervisor's national laws or regulations require that the cross-border operations of
foreign banks are subject to prudential, inspection and regulatory reporting requirements
similar to those for domestic banks."4
It is clear, then, that consolidated supervision is not intended to displace host-country
supervision. Instead, as the Basel Committee has regularly noted, the two are intended to be
complementary, so as to assure effective oversight of large, internationally active banks.
Similarly, the stated purpose of the Basel Committee in requiring consolidated capital
requirements is not to remove from host countries any responsibility or discretion to apply
regulatory capital requirements, but to "preserve the integrity of capital in banks with
subsidiaries by eliminating double gearing."5 Likewise, and contrary to suggestions that are
sometimes made, the capital accords and frameworks developed by the Basel Committee
have always been explicitly minimum requirements. They are floors, not ceilings.
Finally, it is worth noting that, in establishing a post-crisis framework for domestic
systemically important banks (D-SIBs), the Basel Committee made clear that a host country
may in appropriate circumstances designate domestic operations of a foreign bank as
systemically important for that country, even if the parent foreign bank has already been
designated a global systemically important bank (G-SIB).6 The idea informing the newly
created concept of a D-SIB is that an entity whose stress or failure could destabilize a
domestic financial system might thereby indirectly destabilize the international financial
system. Thus, the D-SIB category carries along with it higher loss-absorbency requirements
than are generally applicable to domestic banks, although perhaps not as high as
requirements for G-SIBs. Of course, our regulation for foreign banking organizations (FBOs)
does not entail D-SIB designation or require higher than generally applicable loss
absorbency. But I cite this feature of the D-SIB framework that permits designation of the
domestic operations of foreign G-SIBs because it reflects rather clearly the principle that the
specific characteristics of domestic markets may call for regulation of foreign banks in the
host country, not just at a consolidated level.
In short, the work of the Basel Committee over the years has not been directed at restraining
host-country authorities from supervising and regulating foreign banking operations in their
country. On the contrary, the committee has repeatedly asserted the complementary
responsibilities of both home and host countries to oversee large, internationally active
banking groups, in the interests of both national and international financial stability. And the
committee has frequently returned to this set of issues in responding to developments that
pose a threat to the safety and soundness of the international financial system.
The shift in foreign bank activities
Unfortunately, neither the Basel Committee nor national regulators responded in a timely
fashion to the magnitude of the expansion in scale and scope of the world's largest banking
organizations in the roughly 15 years before the financial crisis. As illustrated in figure 1, at
the end of 1974, just before the Basel Committee was created, the assets of the world's
10 largest banking organizations together equaled about 8 percent of global GDP. The three
largest were all American - BankAmerica, Citicorp, and Chase Manhattan. But their
combined assets were equal to less than 3-1/2 percent of world GDP and, as illustrated in
figure 2, about 10 percent of the GDP of their home country, the United States. By 1988 the
combined assets of the world's 10 largest banking organizations as a proportion of world
GDP had nearly doubled to about 15 percent, a ratio that held constant during the
succeeding decade, at the beginning of the emerging market financial crisis in 1997.
Then the explosive growth began. In the next decade - that is, up to the onset of the financial
crisis in 2007 - the combined assets of the world's 10 largest banks as a share of global
GDP nearly tripled, to about 43 percent. The largest bank in the world at that time, Royal
Bank of Scotland (RBS), had assets equivalent to about 6.8 percent of global GDP, nearly
twice the comparable figure for the three largest banks combined in 1974. Adding the assets
of Deutsche Bank and BNP Paribas - the second and third largest banks in 2007 - to those
of RBS, the three had combined assets equal to about 17 percent of global GDP. And each
of the three had assets nearly equal to, or in one instance substantially more than, the GDP
of its home country. Even the eighth-ranked bank, UBS, had assets well over four times the
GDP of its home country, Switzerland.
Not only did the size of the largest banks change dramatically, so, too, did their scope,
reflecting the overall integration of capital market and traditional lending activities that
accelerated in the decade and a half preceding the crisis. This trend was particularly
apparent in the United States and the United Kingdom, homes to the world's two largest
financial centers. In the United States, the proportion of foreign banking assets to total U.S.
banking assets has remained constant at approximately one-fifth since the late 1990s. But
the concentration and character of those assets have changed noticeably. Today there are
as many foreign as U.S.-owned banks with at least $50 billion in U.S. assets, the threshold
established by the Dodd-Frank Wall Street Reform and Consumer Protection Act for banks
for which more stringent prudential measures must be established.7 Perhaps even more
important was the shift in composition of foreign bank assets in the 15 years before the crisis,
with the proportion of assets held in the U.S. broker-dealers of the 10 largest FBOs rising
from approximately 15 percent to roughly 50 percent.8 Today, 4 of the top 10 broker-dealers
in the United States, and 12 of the top 20, are owned by foreign banks.
Meanwhile, even the traditional branching model of large foreign commercial banks in the
United States had changed. 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 $600 billion on a net basis by 2008.9
A good bit of this short-term funding was used to finance long-term, U.S. dollar-denominated
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.
dollardenominated asset-backed securities and other securities held by Europeans increased
significantly between 2003 and 2007, much of it financed by the short-term,
dollardenominated liabilities of European banks.10
Just as regulatory systems did not, in the years preceding the crisis, address vulnerabilities
such as reliance on short-term wholesale funding that were created by the integration of
capital markets and traditional lending, so they did not respond to the transformation of
foreign banking operations. Accordingly, just as home countries of systemically important
banks have been playing catch-up on capital, liquidity, and other requirements, so host
countries of very large foreign banking operations are playing catch-up in dealing with the
very different character of many internationally active banks from that of 20 or 30 years ago.
The regulatory response
In a sense, the major strengthening during the past few years of capital and liquidity
requirements for internationally active banks - including the capital surcharge for banks of
global systemic importance - has to date been the most important international regulatory
response to the revealed vulnerabilities associated with large foreign banking operations.
Building capital and improving the liquidity positions of banks on a consolidated basis is
surely a key step toward assuring the stability of major FBOs in host countries.
Of course, these agreed changes have not yet been fully implemented. It is critical not just
that all jurisdictions adopt appropriate regulations that fully incorporate the new Basel
standards, but also that we ensure our banks will be substantively, and not just formally,
compliant as the various transition target dates are reached. It is also the case that there is
more to be done in addressing the risks posed by large global banking organizations,
including additional measures to deal with the run risks associated with short-term wholesale
funding and ensuring that even the largest firms can be successfully resolved without either
creating major systemic problems or requiring an infusion of public capital. I will return to
these subjects a bit later, in discussing the cooperative agenda that lies ahead for the United
States, Europe, and our partners throughout the world.
First, though, I want to describe how Europe, the United Kingdom, and the United States are
dealing with the vulnerabilities associated with large foreign banking operations, and thus are
fulfilling their responsibilities as host-country supervisors. I discuss the United Kingdom
separately from the EU both because it is outside the euro zone and because, as a host
jurisdiction, it is more similar to the United States than to other EU member states or, indeed,
to any other country in the world.
The EU has not, since the crisis, specifically adjusted the structure of regulation of foreign
banks by its member states in their role as host supervisors. For more than a decade before
the crisis, EU member states had prudently required that not only commercial banking, but
also investment banking subsidiaries of foreign (non-EU-based) banking organizations, be
subject to Basel capital requirements in the same way as EU-based firms. With the adoption
of CRD IV,11 the directive implementing the new EU capital requirements, Basel III will now
be applied to all EU firms, including EU bank and investment bank subsidiaries of non-EU
banking organizations. Branches of non-EU banks are generally not subject to local
requirements.
Before the crisis and the subsequent development of Basel III, there was no leverage ratio
requirement in EU capital directives. Insofar as a new leverage ratio is part of the Basel III
package agreed upon internationally, one would anticipate that it will be applied to
commercial banking and investment banking firms in the EU, again including local
subsidiaries of non-EU firms. Likewise, one would anticipate that the Basel III liquidity
requirements will be implemented in the EU in accordance with the internationally agreed
timeline and, again, that it will apply to EU subsidiaries of FBOs.
A greater challenge for the EU has been dealing with banks headquartered in one EU
country but doing business in other EU countries under the "single passport," which basically
allows for full access in the rest of the EU, with supervision provided only by the home
country. During the crisis, there were some notable instances of banking stresses and
failures involving such institutions, with consequent negative effects on depositors,
counterparties, and economies in other parts of the EU. Much of the ongoing post-crisis
reform agenda in Europe seems directed at ensuring the safety and soundness of EU-based
institutions. The most important of these changes may be the assumption by the European
Central Bank of supervisory responsibility for larger euro area banks. And, as we saw just
last week, work continues on the long process of creating a credible resolution mechanism
for those banks.
As a member state of the EU, the United Kingdom of course implements the EU policies I
have just described. But that country has applied an additional set of requirements on the
local operations of foreign banks, particularly with respect to liquidity. The Prudential
Regulation Authority of the Bank of England applies local liquidity requirements to
commercial and investment banking subsidiaries of non-U.K. banks, requiring them to hold
local buffers as determined by internal stress tests with both 14- and 90-day components.
The assumptions on which the stress tests are premised are quite strict. For example, the
U.K. subsidiary generally must assume zero inflows from non-U.K. affiliates - even for claims
on non-U.K. affiliates with short terms that mature within the stress test period - and
100 percent outflows to non-U.K. affiliates. The requirements generated by the test are
subject to a supervisory review and add-on that for some firms has resulted in a significant
increase in the buffer requirement. Branches of foreign commercial banks may in some
circumstances be subject to local liquidity requirements as well.
The U.K. initiative in applying local liquidity requirements is wholly understandable in light of
the difficulties encountered because of stress on foreign institutions, including the Lehman
bankruptcy, during the crisis. Because London is one of the world's two largest financial
center hosts, the United Kingdom is the only country other than the United States hosting
numerous, very large broker-dealers that are owned by foreign banks and also a broad array
of commercial bank subsidiaries and branches that are owned by foreign banks. In fact, the
six institutions headquartered outside the United States and the United Kingdom that are in
the top three tiers of G-SIBs hold roughly 40 percent of their worldwide assets in those two
jurisdictions.12 Thus the U.K. initiative on liquidity and its internal debates on matters such as
structural supervision, the Vickers proposals, and stress testing have all been very instructive
for the Federal Reserve Board. Even where we have eventually adopted somewhat different
approaches, we respect the motivation and scrupulousness of the U.K. banking authorities in
addressing the systemic vulnerabilities posed by FBOs and in fulfilling their responsibility to
the rest of the world to assure the stability of one of the world's two most important financial
centers.
Unlike the EU, the United States did not - prior to the financial crisis - require that all
brokerdealers and investment banks meet Basel capital standards. The legacy of the
GlassSteagall Act, which had separated investment banking from commercial banking, meant that
only commercial banks were subject to the prudential regulation of the federal banking
agencies. In Europe, the dominance of universal banking, or variants thereon, led more
naturally to application of capital and other prudential standards to all forms of banking
activity. Even after the Gramm-Leach-Bliley Act removed the remaining barriers to affiliation
between investment banks and commercial banks in the United States, Basel capital
requirements applied at a consolidated level to the activities of an investment bank or
brokerdealer only if it did affiliate with a commercial bank. Thus, the five large "free-standing" U.S.
investment banks were generally not subject to full application of Basel capital standards.
During the crisis, the ill-advised nature of this regulatory state of affairs became apparent.
The decline in value of many mortgage-backed securities and the consequent market
uncertainty as to the true value of that entire class of securities raised questions about the
solvency of major broker-dealers. Because the dealers were so highly leveraged and
dependent on short-term financing, the uncertainty also led to serious liquidity strains, first at
Bear Stearns and Lehman Brothers and eventually at most dealers - domestic and foreign
owned. Bear Stearns and Merrill Lynch were acquired by existing bank holding companies
after coming close to failure. Lehman Brothers went bankrupt. Goldman Sachs and Morgan
Stanley became bank holding companies.
Through its Primary Dealer Credit Facility, the Federal Reserve provided substantial liquidity
to the broker-dealer affiliates of the bank holding companies, as well as to the primary dealer
subsidiaries of foreign banks. At the same time, the shift in strategy of many foreign banks
toward using their U.S. branches to raise dollars in short-term markets for lending around the
world created another set of vulnerabilities that resulted in substantial and, relative to total
assets, disproportionate use of the Federal Reserve's discount window by foreign bank
branches.
The experience of the crisis made clear, first, that the perimeter of prudential regulation
around U.S. financial institutions needed to be expanded. As noted a moment ago, this had
occurred de facto during the crisis. The Dodd-Frank Act has given a legal foundation for this
change, first by mandating that Goldman Sachs and Morgan Stanley will remain subject to
consolidated prudential regulation even were they to divest their insured depository
institutions and, second, by giving the Financial Stability Oversight Council the authority to
designate other financial firms as systemically important, a step that would place them under
Federal Reserve regulation and supervision. Dodd-Frank further required the Federal
Reserve to apply progressively more stringent prudential regulation to bank holding
companies with more than $50 billion in assets.
Congress also required the Federal Reserve to apply special prudential standards to large
FBOs. As I have already implied, much of what we have done is simply to catch up to EU
and U.K. practice. Under our recently finalized Section 165 enhanced prudential standards
regulation, an FBO with U.S. non-branch assets of $50 billion or more must hold its U.S.
subsidiaries under an intermediate holding company (IHC), which must meet the risk-based
and leverage capital standards generally applicable to bank holding companies under U.S.
law.13 Such an FBO must also certify that it meets consolidated capital adequacy standards
established by its home-country supervisor that are consistent with the Basel Capital
Framework. FBOs with combined U.S. assets of $50 billion or more must also meet liquidity
risk-management standards and conduct internal liquidity stress tests. The IHC must
maintain a liquidity buffer in the United States for a 30-day liquidity stress test. The U.S.
branches and agencies of an FBO must maintain a liquidity buffer in the United States equal
to the liquidity needs for 14 days, as determined by a 30-day liquidity stress test.14 The IHCs
of FBOs must also conform to certain risk-management and supervisory requirements at the
IHC level.
Structurally, the U.S. capital requirements for FBOs are similar to those that apply to foreign
banks in the EU. That is, generally applicable Basel capital requirements are applied to the
U.S. operations of FBOs that own local banking subsidiaries, investment banks, and
brokerdealers. In fact, the new U.S. rules are somewhat more favorable to foreign institutions, in
that they only apply once the non-branch U.S. assets of an FBO exceed $50 billion. That
dollar amount, incidentally, is the same as the Dodd-Frank threshold for more stringent
prudential measures, though note that this statutory threshold applies if the total assets of
any U.S. banking organization - foreign, as well as domestic - exceed that level. As in the
EU, the capital requirements do not apply to U.S. branches of foreign banks, even though the
crisis experience provides some credible arguments for doing so.
The leverage ratio requirement has received particular attention. One complaint is that the
foreign operations of U.S. banks are not subject to leverage ratios for their local operations. It
is true that many foreign countries - including the EU member states - do not currently have
leverage ratio standards for their banks. As noted earlier, however, one may reasonably
expect that those countries will be implementing the Basel III leverage ratio in a timely
fashion. Also, I would note in passing that the U.S. leverage ratio requirement for foreign
firms will be phased in more slowly than originally proposed, so as to align it more closely
with the effective date of the Basel III leverage ratio requirement.
A second complaint is that there is something unfair about the United States requiring an
FBO to meet the international leverage ratio in its U.S. operations, because its operations
may be heavily weighted toward broker-dealer activities, which generally have higher
leverage, whereas the leverage ratio for U.S. firms is based on their global operations. Again,
one suspects that the foreign operations of U.S. firms could be subject to a similar ratio
requirement abroad as countries implement their Basel III commitments. However, quite
apart from what may happen in the future, there are two U.S.-based firms - Goldman Sachs
and Morgan Stanley - whose global business mix resembles that of the U.S. subsidiaries of
FBOs that are predominantly engaged in broker-dealer activities in the United States. In fact,
under the enhanced supplementary leverage ratio the Board proposed during the summer,
these and other U.S. G-SIBs would be subject to a higher Basel III leverage ratio
requirement (5 percent) than would apply to FBO IHCs (3 percent).
The applicable liquidity requirements, while somewhat differently defined, are roughly
comparable to those already applicable to FBOs in the United Kingdom. The similar positions
of our two nations as host countries for foreign bank operations heavily involved in trading
and significantly reliant on potentially runnable short-term wholesale funding explain this
rough parallelism.
The most notable departure of the new U.S. FBO standards from existing EU and U.K.
practice lies in the IHC requirement for foreign banks with large domestic operations. Given
the structure of U.S. financial regulation that is a legacy of Glass-Steagall, as well as the
efforts by a small number of very large foreign banks to evade the intent of Congress that
capital standards apply to their U.S. operations, we needed to create this structural
requirement. It is unclear how much difference this makes for the capital requirements of
FBOs in the United States as opposed, say, to those of U.S. operations in the EU. That
would depend on the existence and size of financial affiliates owned by the U.S. firm that are
not subject to Basel standards directly. In any case, it seems sound prudential practice - and
consistent with the various Basel Committee principles to which I earlier referred - that large
domestic operations of foreign banks meet capital standards on the basis of all exposures in
the host jurisdiction and, indeed, that they manage their risks in that country across all their
affiliates.
"Balkanization" and home-host responsibilities
To return to the issue of Balkanization, three things should now be apparent. First, in its new
capital regulations applicable to FBOs, the United States is more a follower of the pattern set
by the EU than it is an initiator of new kinds of requirements. Of course, a few foreign banks
would prefer the old system under which they held relatively little capital in their very
extensive U.S. operations. But that was neither safe for the financial system nor particularly
fair to their competitors - U.S. and foreign - that hold significant amounts of capital here.
Indeed, a firm that is genuinely well capitalized, including holding the G-SIB surcharge at its
global consolidated level, should require only moderate adjustment efforts during the
transition period established in the FBO rule.
Second, there is considerable scope for a foreign bank to integrate its U.S. operations with
its global activities within the rule the Federal Reserve adopted last month. For example,
while foreign firms with more than $10 billion in non-branch assets have some additional
reporting requirements, only when U.S. non-branch assets rise above $50 billion do the
quantitative Basel capital requirements become applicable to the U.S. subsidiaries.
Moreover, no capital requirements apply to branches so long as their parent is subject to
home-country consolidated capital rules consistent with Basel standards. The U.S.
operations of FBO branches and subsidiaries will not be subject to "due from" restrictions.
They remain free to lend money to their worldwide affiliates; they must simply do so with a
more stable funding base. Finally, I note that many FBOs, like many U.S.-based banks, have
made considerable progress in reducing dependence on short-term wholesale funding and in
building capital. To some extent, the new requirements are intended to preserve this
progress.
Third, the capital and liquidity requirements that do apply are wholly consistent with the
responsibility of host-country supervisors to assure financial stability in their own markets.
Collectively, foreign banks with a large presence in the United States conduct activities of a
scope, and at a scale, that could lead to problems for the U.S. financial system should they
come under stress. Realistically, exposures and vulnerabilities in a large host-country market
are much more difficult for home-country supervisors to assess. Indeed, U.S. regulators
count on the expertise and proximity of U.K. regulators in overseeing the London operations
of large U.S. financial institutions to enhance the effective consolidated supervision and
regulation for which we are responsible.
On the issue of home-host-country coordination in regulating large, globally active banking
organizations, I would make three additional points. First, our FBO capital requirements, like
those of the EU for foreign commercial and investment banks, are based on the capital rules
agreed to in the Basel Committee.15 Thus, there is an overall compatibility between national
and international rules with respect to applicable definitions, standards, and required ratios.
Second, home countries must implement and enforce faithfully at a consolidated level these
same capital rules. More broadly, home-country supervisory expectations for strong
consolidated capital levels, liquidity positions, and risk-management practices are likely to
facilitate compliance with domestic requirements for large FBOs of the sort applicable in the
United States and the EU. It is also important that home countries assure the credibility of
reso