Source: https://www.cadwalader.com/resources/clients-friends-memos/Federal_Reserve_Governor_Tarullo_Calls_for_Increased_US_Regulation_of_Foreign_Banki
Timestamp: 2019-04-25 01:17:13+00:00

Document:
In a speech delivered last week to the Yale School of Management, Federal Reserve Governor Daniel K. Tarullo signaled that the Board of Governors of the Federal Reserve System (FRB) is considering major changes to the regulation of foreign banks and their affiliates in the United States. Governor Tarullo, the FRB’s banking expert and the Governor most likely to take the lead role on matters relating to financial reform, indicated that the FRB is considering requiring that foreign banks with subsidiaries in the United States hold those banking and nonbanking subsidiaries in a U.S.-based holding company that would be regulated by the FRB with respect to prudential matters, including capital and liquidity.
Foreign banks play a significant role in the U.S. economy. There are nearly 250 branches and agency offices in the U.S., representing more than 150 foreign banks. These branches and agency offices are responsible for nearly 17% of commercial loans in the U.S., and hold more than 9% of U.S. deposits. According to Governor Tarullo, at least 23 foreign banks have U.S. banking assets exceeding $50 billion,1 the threshold subjecting banking institutions to heightened regulation under Dodd-Frank. In addition, half of the ten largest broker-dealers in the U.S. are owned by foreign banks. The manner in which these foreign banks are regulated depends on the manner in which the foreign bank conducts banking operations in the U.S. (whether by establishing branch or agency offices in the U.S., or by acquiring a U.S. banking subsidiary in the U.S.), as further explained below.
Foreign Banking Organizations. Under current law, foreign banks are permitted to establish deposit-taking branches or non-depository offices (known as “agency offices”) in the U.S., provided the foreign bank submits an application to the FRB. In reviewing the application, the FRB considers a number of factors, including whether the foreign bank is subject to “comprehensive consolidated supervision” (CCS) by its home country regulator.2 Assuming the FRB approves the creation of a branch or agency office, the branch or agency office must then, in the case of a state branch or agency office, be approved by a state banking department or, in the case of a Federal branch or agency office, be approved by the Office of the Comptroller of the Currency (OCC).
Foreign banks that obtain approval to establish a branch or agency office (or a banking subsidiary) in the U.S., referred to as “foreign banking organizations” (FBOs), are required to comply with the Bank Holding Company Act as if they are a bank holding company. As a result, FBOs are subject to examination and supervision by the FRB (although the FRB largely confines itself to the FBO’s U.S. operations), and the U.S. activities of the FBO are required to comply with the activity restrictions of the Bank Holding Company Act (and therefore cannot engage in nonfinancial activities in the U.S. and cannot engage in certain insurance and securities activities in the U.S. unless the FBO becomes a “financial holding company” (FHC)).
Non-FBO Foreign Banks. Foreign banks that do not establish a branch, agency office, or banking subsidiary in the U.S. (and thus are not FBOs) are subject to little U.S. banking regulation. These foreign banks historically are not subject to any capital regulation in the U.S. and are not required to conform the activities of their U.S. subsidiaries to the requirements of the Bank Holding Company Act.
At the Yale School of Management, Governor Tarullo outlined what he termed a “practical and reasonable way forward” in the U.S. regulation of foreign banks. Governor Tarullo noted that the profile of foreign bank operations in the United States changed significantly in the run-up to the financial crisis, shifting from a “lending branch” model to a “funding branch” model, in which U.S. branches of foreign banks began borrowing large amounts of U.S. dollars “to upstream to their parents.” The financial crisis, Governor Tarullo argued, has served to reveal the financial stability risks associated with the foreign banking model as it has evolved in the United States. One of these dangers, Governor Tarullo noted, is that a global bank's capital and liquidity can end up “trapped at the home entity” in the event of a failure.
A “more uniform structure” for the “largest” U.S. operations of foreign banks, which would require that they establish a top-tier U.S. intermediate holding company (IHC) over all U.S. bank and non-bank subsidiaries. Governor Tarullo argued that this would allow for more consistent supervision across foreign banks, and would also reduce the ability of foreign banks to avoid U.S. consolidated-capital regulations. The U.S. branches of foreign banks would themselves remain outside the IHC structure.
The same capital and prudential rules applicable to U.S. bank holding companies would also apply to U.S. IHCs.
Governor Tarullo provided a number of reasons as to why such a shift in U.S. policy is required, including the following: (i) non-U.S. banks have become net borrowers in the U.S., rather than net lenders to the United States; (ii) during the financial crisis, non-U.S. banks were directly supported by the FRB (as well as their home country regulators); (iii) in a future financial crisis, Governor Tarullo believes that non-U.S. governments may be less willing or able to support the U.S. branches of their home country banks, thus increasing their potential need for support from the FRB or the potential that their failure disrupts the U.S. economy; and (iv) non-U.S. banking organizations play a major role in the U.S. banking and securities markets.
FBOs with U.S. banking subsidiaries will be required to maintain an intermediate U.S. bank holding company. This appears to be a direct response to decisions by several FBOs to effect corporate reorganizations so as to hold their U.S. banking subsidiaries directly from abroad, which resulted in the FBOs not being subject to capital requirements that would apply to the U.S. bank holding companies from the repeal of SR 01-01, the Collins Amendment and the rollout of prudential capital requirements on U.S. bank holding companies with assets above $50 billion.
FBOs without U.S. banking subsidiaries would be required to establish an IHC as a U.S. holding company. While this IHC would not be a bank holding company (because it would not own a bank), the IHC would nonetheless be subject to examination and supervision by the FRB, as well as the capital requirements imposed by the Bank Holding Company Act. In addition, the IHC would be subject to the prudential requirements imposed by Dodd-Frank Act Sections 165 & 166 (including increased capital requirements, leverage limits, liquidity requirements, risk management requirements, resolution planning, credit exposure reports, and early remediation requirements). The branches and agency offices of the FBO would exist outside of the IHC structure (and thus remain as a U.S. office of the foreign bank) and would not be subject to new standalone capital requirements, but would be subject to liquidity requirements.
It is unclear whether, or how, the proposal would apply to non-FBO foreign banks, i.e., foreign banks without a branch or agency office, or banking subsidiary, in the United States. While Governor Tarullo’s concerns regarding the risk posed by large U.S. broker-dealer subsidiaries of foreign banks could be construed to apply equally to foreign banks that do not have a U.S. banking presence but conduct other business here, it is not clear whether the FRB can regulate such entities without Congressional action, inasmuch as the International Banking Act confers on the FRB the authority to regulate only those foreign banks that maintain a branch or agency office in the United States. If the FRB does attempt to regulate such non-FBO foreign banks, it would subject such entities to FRB regulation for the first time.
Please feel free to contact any of the following Cadwalader attorneys if you have any questions about this memorandum.
1 Current publicly available data from the FRB (based on June 30, 2012, statistics) lists 20 FBOs with U.S. banking assets in excess of $50 billion. See http://www.federalreserve.gov/releases/iba/201206/bycntry.htm.
2 The CCS requirement and the requirement for FRB approval of a branch or agency office were added by the Foreign Bank Supervision Enhancement Act of 1991.
3 See, e.g., 12 U.S.C. §§ 3102(b), 3105(h).
4 See 12 U.S.C. § 3105(a). The reserve requirements apply only if the foreign banking organization has worldwide assets exceeding $1 billion. Id.
5 See 12 U.S.C. § 3105(c).
6 12 U.S.C. § 3102(g). State branches and agency offices are subject to similar requirements under State law. See, e.g., N.Y. Banking Law § 202-b.
7 See 12 U.S.C. § 3102(j); see generally N.Y. Banking Law, Article 13.
8 12 C.F.R. § 225.2(r).
9 FRB Supervision & Regulation Letter 01-01 (Jan. 5, 2001). SR 01-01 is applicable only if the FBO has met the standards of, and has elected to be, a “financial holding company.” An FBO that is not a financial holding company may not rely on SR 01-01.
10 12 U.S.C. § 5371(b)(4)(E) (as added by Dodd-Frank Act § 171(b)(4)(E)).
11 See 12 U.S.C. §§ 5365 & 5366 (as added by Dodd-Frank Act §§ 165 & 166). While the FRB has issued proposed prudential regulations, these proposals would not apply to FBOs. Instead, the FRB indicated that it would issue a separate proposed regulation with respect to prudential regulation of FBOs. See Board of Governors of the Federal Reserve System, Proposed Regulation, Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies, 77 Fed Reg. 594 (Jan. 5, 2012). The FRB’s stress testing regulations, which have been issued in final form, also do not apply to FBOs (other than with respect to any U.S. subsidiary bank holding company). See Board of Governors of the Federal Reserve System, Final Regulation, Annual Company-Run Stress Test Requirements for Banking Organizations With Total Consolidated Assets Over $10 Billion Other Than Covered Companies, 77 Fed. Reg. 62396 (Oct. 12, 2012); Board of Governors of the Federal Reserve System, Final Regulation, Supervisory and Company-Run Stress Test Requirements for Covered Companies, 77 Fed. Reg. 62378 (Oct. 12, 2012). Again, the FRB indicated that it would issue a separate regulations with respect to stress-testing by FBOs. On the other hand, the FRB has finalized its living will regulations required by Section 165(d), which do apply to the U.S. operations of FBOs. See Board of Governors of the Federal Reserve System, Final Regulation, Resolution Plans Required, 76 Fed Reg. 67323 (Nov. 1, 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.
Some observers will, I am sure, ask if it is necessary to depart from the prevailing firm-by-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.

References: § 3105
 § 3105
 § 3102
 § 202
 § 3102
 § 225
 § 5371
 § 171