Bank Capital Requirements: Potential Effects of New Changes on Foreign Holding Companies and U.S. Banks Abroad
Published: 2012-01-17T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: During the 2007-2009 financial crisis, many U.S. and international financial institutions lacked capital of sufficient quality and quantity to absorb substantial losses. In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) introduced new minimum capital requirements for bank and savings and loan (thrift) holding companiesincluding intermediate holding companies of foreign banks. Intermediate holding companies are the entities located between foreign parent banks and their U.S. subsidiary banks. These companies held about 9 percent of total U.S. bank holding companies assets as of September 2011. The Dodd-Frank Act also required GAO to examine (1) regulation of foreign-owned intermediate holding companies in the United States, (2) potential effects of changes in U.S. capital requirements on foreign-owned intermediate holding companies, and (3) banks views on the potential effects of changes in U.S. capital requirements on U.S. banks operating abroad. To conduct this work, GAO reviewed legal, regulatory, and academic documents; analyzed bank financial data; and interviewed regulatory and banking officials and market participants.
GAO makes no recommendations in this report. GAO provided a draft to the federal banking regulators (Federal Reserve, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency) for their review and comment. They provided technical comments that were incorporated, as appropriate.
section_title: What GAO Found
paragraphs: Foreign-owned intermediate holding companies can engage in the same activities as and generally are regulated similarly to their U.S. counterparts. The Board of Governors of the Federal Reserve System (Federal Reserve) oversees the regulation, supervision, and examination of foreign and U.S. bank and thrift holding companies. As of the end of 2010, four qualifying foreign-owned intermediate holding companies (exempt holding companies) were relying on a capital exemption, which allowed them to operate with significantly lower capital than U.S. peers. Federal Reserve officials noted that allowing capital to be held at the foreign parent bank (consolidated) level was consistent with its supervision for U.S. bank holding companies and met international standards for home-host supervision. The Dodd-Frank Act eliminated the capital exemption in order to enhance equal treatment of U.S.- and foreign-owned holding companies by requiring both types of companies to hold similar capital levels in the United States. As a result, these exempt holding companies must meet minimum capital standards that are not less than those applicable to Federal Deposit Insurance Corporation-insured depository institutions by July 2015.
The four exempt holding companies have been considering various actions to comply with new capital requirements, and the effects of eliminating the capital exemption on competition and credit cost and availability likely would be small. Specifically, these companies are considering raising capital, decreasing their holdings of risky assets, restructuring, or adopting a combination of these actions. GAOs analysis of loan markets suggests that the elimination of the capital exemption likely would have a limited effect on the price and quantity of credit available because the affected banks have relatively small shares of U.S. loan markets, which are competitive. These four companies accounted for about 3.1 percent of the loans on the balance sheets of all bank holding companies in the United States as of year end 2010. In addition, GAOs review of the academic literature and econometric analysis both suggest that changes in capital rules that affect the exempt companies would have a limited effect on loan volumes and the cost of credit and add minimally to the cumulative cost of new financial regulations. Although the impact on the price and quantity of credit available may vary across regions, modeling limitations restricted GAOs ability to identify regional differences.
Market participants expressed uncertainty about how changes in capital requirements might affect the competitiveness of U.S. banks operating abroad, partly because international regulatory capital requirements have yet to be implemented. The largest internationally active U.S. banks derived about one-third of their 2010 revenues from operations abroad. They face a variety of domestic and foreign competitors and are subject to multiple regulatory regimes. Bank officials expressed uncertainty about how changes in capital requirements will affect their cost of capital, lending ability, and competitiveness. Furthermore, they were concerned that fragmented or conflicting regulations across national jurisdictions might restrict banks ability to use capital efficiently. Many U.S. banks GAO interviewed expressed concerns about the added costs of compliance with multiple regulatory regimes and the impact of the Act on the global competitiveness of U.S. banks, but these concerns would need to be considered against the potential benefits of a safer and sounder financial system.

section_title: Letter
paragraphs: The 2007-2009 financial crisis revealed that many U.S. and international  financial institutions lacked capital of sufficient quality and quantity to  absorb substantial losses. In response, banking regulators around the  world moved to strengthen requirements for capital adequacy. In the United  States, the Dodd-Frank Wall Street Reform and Consumer Protection Act  (Dodd-Frank Act) introduced new capital requirements for bank and  savings and loan (thrift) holding companies. These requirements also  apply to intermediate holding companies of foreign banking organizations  (hereafter, such foreign banking organizations will be referred to as foreign  parent banks or foreign banks).held approximately $1.6 trillion in U.S. assets in 2011, representing about 9   These intermediate holding companies  percent of total U.S. bank holding companies’ assets.requires these holding companies to meet minimum risk-based capital and  leverage requirements that are not less than those applicable to depository  institutions that the Federal Deposit Insurance Corporation (FDIC) insures.  These requirements are intended to improve the capital and liquidity  positions of such holding companies so that they may survive periods of  financial and economic stress—thereby making the financial system more  stable and reducing the likelihood or severity of future financial crises.
Section 174(b) of the Dodd-Frank Act requires us to study the effects of the  new U.S. capital requirements on foreign-owned intermediate holding  companies, taking into account the principles of national treatment and  equality of competitive opportunity, which accord foreign banks the  opportunity to compete in the United States on the same basis as domestic  banks. This report examines (1) the regulation of foreign-owned intermediate  holding companies in the United States, (2) the potential effects of changes  in U.S. capital requirements on foreign-owned intermediate holding  companies, and (3) banks’ views on the potential effects of changes in U.S.  capital requirements on U.S.-owned banks operating abroad.
To describe how foreign bank and thrift holding companies are regulated  in the United States, we reviewed laws and regulations relevant to federal  and state bank and thrift holding companies, regulatory documentation,  and published reports, testimonies, speeches and articles; interviewed a  state bank regulator, the European Commission (a European Union entity  that, among other things, sets out general capital rules that each of the 27  European Union member countries can adopt at their discretion), bank  holding companies, and industry experts; and reviewed prior GAO  reports. In addition, we received written responses to questions from the  European Banking Authority (European banking regulator) and attended a  foreign bank conference on the implications of new capital rules. To  assess the potential effects of changes in capital requirements for foreign- owned intermediate holding companies, we reviewed section 171 of the  Dodd-Frank Act and proposed and final capital rules for foreign-owned  intermediate holding companies and related comment letters. We also  reviewed various proposed and final international capital rules. In  addition, we reviewed Securities and Exchange Commission (SEC)  regulatory filings of foreign bank holding companies. Moreover, we  interviewed officials from the European Commission, foreign and U.S.  bank holding companies, credit rating agencies and industry experts on  the effects of the new capital requirements on foreign banks operating in  the United States. We used the Herfindahl-Hirschman Index (HHI)—a  measure of industry concentration that reflects both the number of firms in  the industry and each firm’s market share—to track loan market  concentration. We compared market shares for foreign-owned  intermediate holding companies (that were and were not subject to U.S.  capital requirements) and U.S. bank holding companies. We obtained  data on assets of foreign-owned intermediate holding companies and  U.S. bank holding companies from SNL Financial—a private financial  database. We obtained a list of foreign-owned intermediate holding  companies and information on whether they were subject to U.S. capital  requirements from the Board of Governors of the Federal Reserve  System (Federal Reserve), which is the consolidated regulator for all  bank and thrift holding companies in the United States. We also obtained  the views of foreign and domestic banks, credit rating agencies, and  industry experts on the cost of capital and lending.
To estimate the effect of capital requirements on the cost and availability of  credit, we developed a modified version of a model commonly used in the  macroeconomics and monetary literature. The data for the model were  obtained from Thomson-Reuters Datastream, the Federal Reserve, and the  Federal Reserve Bank of St. Louis. Because of the limitations associated  with the modeling technique and uncertainty in the parameter estimates,  we compared our results with those of a wider body of research on the  effects of bank capital on lending activity. We obtained and analyzed  relevant empirical studies and applied the estimates from these studies to  the expected changes in capital stemming from the elimination of the  Federal Reserve’s capital exemption for certain institutions.
To identify banks’ views on the potential risks from changes in capital  requirements on U.S. banks operating abroad, we interviewed officials  from three U.S. bank holding companies that engaged in significant  international operations and officials from the European Commission. We  summarized studies and congressional testimonies of the potential effects  on U.S. banks’ funding costs, product pricing, and lending activity abroad.
For all of our research objectives, we obtained the views of officials from  the Federal Reserve, Office of the Comptroller of the Currency (OCC),  Office of Thrift Supervision (OTS), FDIC, and the U.S. Department of the  Treasury. We also conducted assessments of the reliability of data  obtained from SNL Financial and other sources and determined that they  were reliable for our purposes. For additional information on the scope  and methodology for this engagement, see appendix I.
We conducted this performance audit from December 2010 to January  2012 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: Foreign banks have been cited as important providers of capital to the  U.S. economy. According to Federal Reserve data, as of September 30,  2011, 216 foreign banks from 58 countries had banking operations in the  United States. They held about $3.4 trillion, or about 22 percent of total  U.S. banking assets; about 25.7 percent of total U.S. commercial and  industrial loans; about 17.5 percent of total U.S. deposits; and about 14.9  percent of total U.S. loans.
section_title: Organization of Foreign Banks in the United States
paragraphs: Foreign banks may operate in the United States under several different  structures, which include branches, agencies, subsidiary banks,  representative offices, Edge Act corporations, Agreement corporations,  and commercial lending companies (see table 1). Most operate through  branches and agencies because as extensions of the foreign parent  bank, they do not have to be separately capitalized and can conduct a  wide range of banking operations.
Both domestic banks and U.S. subsidiary banks of foreign banks may be  owned or controlled by a bank holding company. Holding companies are  legally separate entities from their subsidiary banks, are subject to  separate capital requirements, and are supervised and regulated by the  Federal Reserve. In the United States, bank holding companies are  common and function as the top-tier entity in the corporate structure. In  many foreign countries, notably in Europe, the deposit-taking bank is the  top-tier entity in the corporate structure and bank holding companies are  less common. According to the Federal Reserve, as of September 30,  2011, there were 29 foreign-owned intermediate holding companies in the  United States. This report focuses on changes to the capital requirements  for these entities under the Dodd-Frank Act.
Bank and thrift organizations are required to hold capital so that certain  parties, such as depositors and taxpayers, would not be harmed if the  bank or thrift faced unexpected substantial losses. There are many forms  of capital, the strongest of which do not have to be repaid to investors, do  not require periodic dividend payments, and are among the last claims to  be paid in the event of bankruptcy. Common equity, which meets all of  these qualifications, is considered the strongest form of capital. Weaker  forms of capital have some but not all of the features of common equity.  National banking regulators classify capital as either tier 1—currently the  highest-quality form of capital and includes common equity—or tier 2,  which is weaker in absorbing losses. Different entities within a banking  organization may have different capital requirements. For example, a  subsidiary bank and a broker-dealer in the same corporate structure may  be required to hold different levels of capital, and those capital  requirements are established and supervised by different regulators.
subsections: section_title: International Efforts to Enhance Bank Supervision and Stability of the Financial System
paragraphs: In the 1980s, U.S. and international regulators recognized that common  borrowers and complex products and funding sources had made the world’s  financial markets increasingly interconnected. Regulators also acknowledged  that bank regulatory capital standards generally were not sensitive to the risks  inherent in a bank’s activities and that distressed or failing large, internationally  active banks posed a significant global risk to the financial system. These  concerns underscored the need for international regulatory coordination and  harmonization of capital standards. As a result, in 1988 the Basel Committee  on Banking Supervision (Basel Committee) adopted a risk-based capital  framework known as the Basel Capital Accord (Basel I). Basel I aimed to  measure capital adequacy (that is, whether a bank’s capital is sufficient to  support its activities) and establish minimum capital standards for  internationally active banks. It consisted of three basic elements: (1) a target  minimum total risk-based capital ratio of 8 percent and tier 1 risk-based capital  ratio of 4 percent, (2) a definition of capital instruments to constitute the  numerator of the capital-to-risk weighted assets ratio, and (3) a system of risk  weights for calculating the denominator of the ratio. While the framework was  designed to help improve the soundness and stability of the international  banking system, reduce some competitive inequalities among countries, and  allow national discretion in implementing the standards, it did not explicitly  address all types of risks that banks faced. Rather, it addressed credit risk,  which the Basel Committee viewed as the major risk banks faced at the time.  Over time it became apparent to bank regulators that Basel I was not providing  a sufficiently accurate measure of capital adequacy because of the lack of risk  sensitivity in its credit risk weightings, financial market innovations such as  securitization and credit derivatives, and advancements in banks’ risk  measurement and risk management techniques. The accord was revised and  enhanced multiple times after 1988 because of its shortcomings. For example,  in 1996, Basel I was amended to take explicit account of market risk in trading  accounts. The market risk amendment allowed banks to use internal models  of risks to determine regulatory capital levels. Table 2 identifies some key  features of capital regime enhancements to the Basel accords.
Basel II, adopted in June 2004, aims to better align minimum capital  requirements with enhanced risk measurement techniques and  encourage banks to develop a more disciplined approach to risk  management. It consists of three “pillars”: (1) minimum capital  requirements, (2) a supervisory review of an institution’s internal  assessment process and capital adequacy, and (3) effective use of  disclosure to strengthen market discipline as a complement to  supervisory efforts. Basel II established several approaches (of increasing  complexity) to measuring credit and operational risks. The “advanced  approaches” for credit risk and operational risk use parameters  determined by a bank’s internal systems as inputs into a formula  supervisors developed for calculating minimum regulatory capital. In  addition, banks with significant trading assets, which banks use to hedge  risks or speculate on price changes in markets for themselves or their  customers, must calculate capital for market risk using internal models.  The advanced approaches allow some bank holding companies to reduce  capital from the levels required under Basel I. Large internationally active  U.S. holding companies are implementing the first qualification phase— known as the parallel run—of the Basel II advanced approaches.  Although some of these large companies have begun to report Basel II  capital ratios to their bank regulators, they still are subject to Basel I  capital requirements, as are other U.S. banks. Financial institutions in  most other industrialized countries are subject to the Basel II capital  standards. In response to the 2007-2009 financial crisis, Basel II was  amended in 2009 by Basel II.5 to enhance the measurements of risks  related to securitization and trading book exposures.
Also in response to the 2007-2009 financial crisis, in 2010, the Basel  Committee developed reforms, known as Basel III, which aim to improve  the banking sector’s ability to absorb shocks arising from financial and  economic stress, whatever the source; improve risk management and  governance; and strengthen banks’ transparency and disclosures. The  reforms target (1) bank-level, or microprudential, regulation to enhance  the resilience of individual banking institutions to periods of stress and (2)  systemwide risks that can build up across the banking sector as well as  the amplification of these risks over time. These two approaches to  supervision are complementary, as greater resilience at the individual  bank level reduces the risk of systemwide shocks. Specifically, Basel III  significantly changes the risk-based capital standards for banks and bank  holding companies and introduces new leverage and liquidity  requirements. equity capital requirement of 4.5 percent of risk-weighted assets (the  capital needed to be regarded as a viable concern); a new capital  conservation buffer of 2.5 percent to provide a cushion during financial  shocks to help companies remain above the 4.5 percent minimum; and  more stringent risk-weights on certain types of risky assets, particularly  securities and derivatives. Basel III also defines capital more narrowly  than the previous accords. The new common equity tier 1 capital  measure is limited mainly to common equity because common equity is  generally the most loss-absorbing instrument during a crisis.
Basel III: A Global Regulatory Framework for More Resilient Bank and Banking  Systems, December 2010.
section_title: U.S. Regulation of Foreign-Owned Holding Companies Intended to Achieve Equivalency with Domestic Counterparts
paragraphs: U.S regulation of foreign-owned intermediate holding companies is  intended to be equivalent to regulation of domestic counterparts to help  ensure that foreign bank operations have the opportunity to compete on a  level playing field in the U.S. market. Several laws enacted since 1978  have shaped the regulation of foreign-owned intermediate holding  companies and other foreign-owned banking operations. The  International Banking Act of 1978 (IBA) is the primary federal statute  regulating foreign bank operations in the United States. In passing IBA,  Congress adopted a policy of “national treatment,” the goal of which is to  allow foreign banks to operate in the United States without incurring either  significant advantage or disadvantage compared with U.S. banks. To  implement this policy, IBA brings branches and agencies of foreign banks  located in the United States under federal banking laws and regulations.  IBA and subsequent laws and regulations give foreign banks operating in  the United States the same powers and subject them to the same  restrictions and obligations as those governing U.S. banks, with some  adaptations for structural and organizational differences. For example,  most foreign banks’ operations are conducted through branches, and they  generally can engage in the same activities as branches of U.S. banks.  However, the U.S. branches of foreign banks are prohibited by law from  acquiring deposit insurance from FDIC, and therefore may not accept  retail deposits, whereas branches of U.S. banks can.
In 1991, Congress passed the Foreign Bank Supervision Enhancement   This Act, which amended IBA, authorizes the Federal  Act (FBSEA). Reserve to oversee all foreign bank operations in the United States.
Foreign banking organizations seeking to establish subsidiaries,  branches, or agencies in the United States must apply for an operating  charter from either OCC (national charter or federal license) or state  banking agency (state license). The Federal Reserve must also approve  these applications. The Federal Reserve’s approval process involves  determining the soundness of the foreign parent bank’s activities.  Specifically, the Federal Reserve assesses, among other factors, the  extent to which the home country supervisor (1) ensures that the foreign  parent bank has adequate procedures for monitoring and controlling its  activities globally, (2) obtains information on the condition of the foreign  bank and its subsidiaries and offices outside the home country through  regular reports of examination and audits, (3) obtains information on the  dealings and relationships between the foreign bank and its affiliate  companies, and (4) receives from the bank consolidated financial reports  for analyzing the bank’s global financial condition.
Another important requirement in the Federal Reserve’s approval process  includes assessing the quality of supervision provided by the applicant’s  home country supervisor. Specifically, the Federal Reserve determines  the extent to which (1) the home country supervisor evaluates prudential  standards, such as capital adequacy and risk asset exposure, on a global  basis, and (2) the foreign parent bank is subject to comprehensive  consolidated supervision—that is, the home country supervisor monitors  the organization’s overall operations across all legal subsidiaries and  national jurisdictions. If the Federal Reserve is satisfied with the bank  applicant’s safety and soundness and the quality of the home country  supervision, it can approve the foreign bank applicant (including its bank  and nonbank affiliates) to do business in the United States. As the host  country consolidated supervisor, the Federal Reserve retains full  oversight authority over the foreign bank’s U.S. operations.
12 U.S.C. § 3105(d)(2)(A); see also item 15 of Attachment A to Federal Reserve Form  FR K-2. International Applications and Prior Notifications under Subpart B of Regulation K. application if it found that the home country supervisor actively was  working to establish arrangements for such supervision and all other  factors were consistent with approval.
FBSEA also established uniform standards for all U.S. operations of  foreign banks, generally requiring them to meet financial, management,  and operational standards equivalent to those required of U.S. banking  organizations. For example, FBSEA required the Federal Reserve to  establish guidelines for converting data on the capital of foreign banks to  the equivalent risk-based capital measures for U.S. banks to help  determine whether they meet the U.S. standards. Additionally, foreign  banks’ U.S. operations must be examined regularly for unsafe or unsound  banking practices and are subject to regulatory financial reporting  requirements similar to those for their U.S. counterparts.
The Gramm-Leach-Bliley Act permitted foreign and U.S. bank holding  companies to become financial holding companies, which are authorized  to engage in a wider range of financial activities (such as insurance  underwriting and merchant banking) compared with bank holding  companies. In response to the Gramm-Leach-Bliley Act, the Federal  Reserve modified its long-standing practice of applying its capital  adequacy standards to foreign-owned intermediate holding companies.  Specifically, in its January 5, 2001, Supervision and Regulation Letter 01- 1, the Federal Reserve provided an exemption from complying with its  capital adequacy guidelines (capital exemption) to foreign banks that are  financial holding companies. The Federal Reserve’s supervisory letter  stated that this action was consistent with its treatment of domestic banks  and financial holding companies. Officials noted that domestic firms were  expected to hold capital on a consolidated basis at the parent level, not  the intermediate holding company level. According to the supervisory  letter, the capital exemption recognized that the foreign parent bank  should be able to hold capital on a consolidated basis on behalf of its  subsidiaries.
To qualify for the exemption, the foreign-owned intermediate holding  company had to meet the standards for financial holding company status.  Specifically, for a foreign bank to qualify as a financial holding company,  the Federal Reserve was required to determine that the intermediate  holding company’s parent foreign bank was well capitalized and well  managed on a consolidated basis. Also, its U.S. depository subsidiaries  were required to be well capitalized and well managed. The bank  subsidiaries of foreign bank organizations still were subject to the capital  adequacy framework (risk-based capital and leverage standards) for  insured depository institutions.
A relatively small number of foreign-owned intermediate holding  companies have relied on the capital exemption. The Federal Reserve  reported that 6 of the approximately 50 foreign-owned intermediate  holding companies used the capital exemption (exempt holding company)  at some point during the period from 2001 to 2010. At the time the Dodd- Frank Act was enacted, in July 2010, 5 foreign-owned intermediate  holding companies were relying on the capital exemption. By the end of  December 2010, 1 of these 5 holding companies restructured its U.S.  operations and no longer relied on the capital exemption. Exempt holding  companies generally have operated with less capital than their foreign  and domestic peers in the United States, with 1 such institution operating  with negative risk-based capital ratios.
subsections: section_title: U.S. Regulatory Reform Eliminated Capital Exemption for Certain Intermediate Holding Companies
paragraphs: The Dodd-Frank Act eliminated the capital exemption that the Federal  Reserve provided to certain foreign-owned intermediate holding  companies. The act requires that after a 5-year phase-in period after  enactment of the act, these companies must satisfy the capital  requirements at the intermediate holding company level. The change  requires capital in the United States to support the foreign bank’s U.S.  operations conducted through a holding company and provides ready  capital access for depositor and creditor claims in case the subsidiary  depository or holding company fails and needs to be liquidated.  According to FDIC, the elimination of the capital exemption also was  intended to better ensure that the foreign-owned intermediate holding  company served as a “source of strength” for the insured depository  institution. Furthermore, according to FDIC, subjecting previously  exempted foreign-owned intermediate holding companies to capital  standards would discourage excessive financial leveraging. FDIC and  some market participants have noted that the elimination of the  exemption enhances the equal treatment of U.S. and foreign-owned  holding companies by requiring both types of companies to hold similar  capital levels in the United States. Figure 1, compares the capital  structure of U.S.- and foreign-owned holding companies.
Federal bank regulators have been finalizing proposed rules to implement  the various capital requirements under the Dodd-Frank Act. According to  regulators, they expect to issue final rules in 2012 but did not provide a  specific date. The act requires that the previously exempted holding  companies comply with the new capital adequacy guidelines by July  2015.authority to require any bank holding company to maintain higher levels of  capital when necessary to ensure that its U.S. activities are operated in a  safe and sound manner. This authority may be exercised as part of  ongoing bank supervision or through the bank application process. We   According to the Federal Reserve, it retains its supervisory  describe the different ways in which the exempted companies can satisfy  the new capital requirements later in this report.
section_title: Stricter Capital Adequacy Standards Also Will Apply to Foreign and U.S. Holding Companies
paragraphs: In addition to eliminating the capital exemption for certain foreign-owned  intermediate holding companies, the Dodd-Frank Act requires that bank  and thrift holding companies—domestic or foreign—meet minimum risk- based capital and leverage requirements that are not less than those that  apply to insured depository institutions. The existing minimum capital  requirements (general risk-based capital guidelines) for insured  depository institutions are largely based on Basel I (see fig. 1). Certain  institutions—the largest internationally active holding companies and  insured depository institutions—are subject to the U.S. implementation of  the advanced approaches in the Basel II framework (advanced  approaches capital guidelines). These large internationally active  institutions are required to use their internal models to determine their  risk-based capital levels, but under the Dodd-Frank Act they generally  cannot hold less capital than would be required under the general risk- based capital guidelines for insured depository institutions. These  institutions will be required to calculate their capital under both the  general risk-based capital guidelines and the advanced approaches  capital guidelines.
Risk-Based Capital Standards: Advanced Capital Adequacy Framework—Basel II;  Establishment of a Risk-Based Capital Floor, 76 Fed. Reg. 37, 620 (June 28, 2011). tier 1 capital of bank holding companies. It is expected that the Federal  Reserve will address such items in 2012.
Finally, the Dodd-Frank Act also made changes that restricted the types  of capital instruments that can be included in tier 1. Prior to the Act, the  general risk-based capital guidelines for bank holding companies allowed  such institutions to include hybrid debt and equity instruments in tier 1  capital whereas such instruments did not count in the tier 1 capital of  insured depository institutions. Insured depository institution regulators  (Federal Reserve, FDIC, and OCC) determined that such instruments did  not have the ability to absorb losses as effectively as other forms of tier 1  capital. The specific requirements for the exclusion of hybrid debt or  equity instruments from tier 1 capital vary according to the asset size and  nature of the holding company.
section_title: Overall Effects of Capital Changes for Exempt Foreign- owned Intermediate Holding Companies Likely to Be Limited
paragraphs: The elimination of the Federal Reserve’s capital exemption for foreign- owned intermediate holding companies likely will result in exempt holding  companies restructuring or taking other actions, but the overall effects of  this change on competition among bank holding companies and cost and  availability of credit are likely to be small for various reasons. First, our  analysis of loan markets suggests that eliminating the exemption likely  would have a limited effect on the price and quantity of credit available  because the four banks most affected have relatively small shares of  relatively competitive U.S. loan markets. Second, our review of the  academic literature and our econometric analysis suggest that changes in  capital rules that could affect certain foreign-owned intermediate holding  companies would have a limited effect on loan volumes, and the increase  in the cost of credit likely will add minimally to the cumulative cost of new  financial regulations.
subsections: section_title: Foreign Parent Banks May Restructure or Take Other Actions to Comply with New Requirements
paragraphs: Foreign parent banks may take a variety of actions, including  restructuring, to comply with the new requirements, although most are  waiting for final rules on capital requirements and other Dodd-Frank Act– related provisions before making a decision. To date, banking and other  financial regulators have not issued final rules implementing many of the  Dodd-Frank Act requirements. Foreign bank officials we interviewed told  us that they needed a better understanding of all the new regulatory  provisions in the Dodd-Frank Act before deciding what action to take.  Most of these bank officials told us they have been monitoring how  regulators are implementing certain Dodd-Frank Act provisions, and the  final rules likely will have a great effect on their decisions. These  provisions include the designation and orderly liquidation of systemically  important financial institutions (SIFI) and a prohibition on proprietary  trading.provisions could have a major impact on her bank’s U.S. operations.
One foreign bank official told us that implementation of these  Additionally, questions about how the new Basel III accord and other global  capital rules will be implemented and how they will interact with U.S.  banking regulations have added to foreign banks’ uncertainty about  planning for compliance with the Dodd-Frank Act. For example, in  November 2011, the Basel Committee introduced a framework for  designating global SIFIs. be required to hold additional capital to absorb losses to account for the  greater risks that they pose to the financial system. Foreign bank officials  we interviewed stated that it is too early to tell how new global requirements  will interact with U.S. requirements under the Dodd-Frank Act.
On November 4, 2011, the Financial Stability Board, which is responsible for  coordinating and promoting the implementation of international financial standards (such  as the Basel III accord), designated 29 financial institutions as global SIFIs. See  http://www.financialstabilityboard.org/about/mandate.htm. holding companies that relied on it. These exempt holding companies  and their foreign parent banks can comply in several ways. First, foreign  parents could issue securities (debt or equity) and inject the capital as  equity into the intermediate holding companies. Second, they could  change the mix of risky assets they hold. For example, banks must hold  more capital against certain assets in their portfolio that are considered  higher-risk. The exempt holding companies could sell off these assets  and acquire higher-quality or less-risky assets. Third, they could pass  down profits or retain earnings from foreign parents to U.S. holding  companies. Fourth, foreign parents could restructure their U.S. operations  by removing any activities not considered banking activities from the  exempt holding companies.the exempt holding companies and leave the U.S. banking market.
Finally, the foreign parent banks could close  One foreign parent bank restructured its exempt holding company by  deregistering it in the fall of 2010. Prior to restructuring, the exempt  holding company had a bank subsidiary, a broker-dealer subsidiary, and  several other subsidiaries. The bank accounted for a small percentage of  the exempt holding company’s consolidated assets and revenues, but the  holding company would be subject to the new capital requirement  because it was supervised as a bank holding company by the Federal  Reserve. After the restructuring, the small bank became a subsidiary of  one bank holding company, while the broker-dealer and the other  nonbank entities became subsidiaries of a different holding company that  is not a bank holding company and therefore not subject to bank holding  capital requirements. The foreign bank stated that restructuring would  better align both foreign parent bank and U.S. bank holding company with  new capital requirements.
How the four foreign parent banks with exempt holding companies  choose to comply will vary. For example, officials from one exempt  holding company told us that the foreign parent bank might inject several  billions of dollars in common equity into the intermediate U.S. holding  company. Officials from a second exempt holding company told us they  were considering a combination of actions, including recapitalizing its  holding company by retaining earnings, reducing the risky assets against  which it must hold capital, and potentially restructuring the holding  company. Officials from another exempt holding company said that it  would review business activities under the holding company to reduce  risky assets that would require holding higher amounts of capital. Finally,  the fourth exempt holding company stated in its annual report to SEC that  the holding company might restructure, increase its capital, or both.
section_title: Eliminating the Exemption Likely Will Have Limited Effects on Overall Competition and Credit
paragraphs: Given the size of the market and the holding companies affected,  elimination of the capital exemption for foreign-owned holding companies  under the Dodd-Frank Act likely will have limited effects on the overall  competitive environment and the cost and availability of credit to  borrowers. Our analysis assesses the impact of the four exempt holding  companies exiting the U.S. banking market or raising additional capital to  meet regulatory standards.
The number of exempt holding companies and their shares of most  national loan markets are small. As of December 31, 2010, four exempt  holding companies relied on the Federal Reserve’s capital exemption.  These exempt holding companies accounted for about 3.1 percent of the  loans on the balance sheets of all bank holding companies in the United  States (see table 3). Therefore, any actions they may take to respond to  the elimination of the capital exemption likely will have a small effect on  the overall credit market.
Exempt holding companies accounted for varying amounts of different  types of loans. In 2010, they accounted for less than 5 percent each of  the construction and land loans, residential real estate loans, commercial  real estate loans, commercial and industrial loans, consumer loans, and  leases on the balance sheets of bank holding companies in the United  States. However, they accounted for more than 10 percent each of  agricultural real estate loans and agricultural production loans. Although  exempt holding companies and their foreign parent banks can take a  variety of approaches to comply with the new capital rules, the effects of  those approaches on credit markets—overall or in specific segments— likely will be small because of the relatively small share of the market that  exempt holding companies hold.
U.S. credit markets likely would remain unconcentrated even if exempt  holding companies exited the market and sold their loans to other bank  holding companies. To assess the impact of eliminating the Federal  Reserve’s capital exemption on competition among bank holding  companies, we calculated the HHI, a key statistical indicator used to  assess the market concentration and the potential for firms to exercise  market power. As figure 2 shows, the HHI for the overall loan market for  2010 is well below 1,500—the threshold for moderate concentration—as  are the HHIs for the 13 specific loan markets we analyzed. Because  these loan markets appear to be unconcentrated, bank holding  companies in these markets likely have little ability to exercise market  power by raising prices, reducing the quantity of credit available,  diminishing innovation, or otherwise harming customers as a result of  diminished competitive constraints or incentives at least at the national  level. As we discuss later, to the extent that markets are segmented by  regions, or small businesses are limited in their ability to access credit,  these results may not hold for all customers.
Faced with the elimination of the Federal Reserve’s capital exemption  and new minimum capital requirements under the Dodd-Frank Act,  foreign banks with exempt holding companies could choose to divest their  banks and exit the U.S. banking market. To estimate the effect of this  particular response on loan market concentration, we estimated the  change in loan market concentration on loan markets in two alternative  scenarios in which all four of the exempt holding companies cease  making loans and sell their portfolios to other bank holding companies. In  the first scenario, the assets of exempt holding companies are acquired  by remaining bank holding companies in proportion to their market share.  In the second scenario, the assets of exempt holding companies are  acquired by the largest bank holding company remaining in the loan  market. Since not all exempt holding companies are likely to exit the U.S.  market, these scenarios provide estimates of the effect of the elimination  of the Federal Reserve’s capital exemption on market concentration in the  most extreme cases.
Estimated changes in the HHIs for the overall loan market in these  alternative scenarios indicate that the overall loan market is unlikely to  become concentrated even if all exempt holding companies exited the  U.S. market. As figure 2 shows, the overall loan market remains  unconcentrated in both scenarios, suggesting that the remaining bank  holding companies still would not have sufficient potential to use market  power to increase loan prices above competitive levels or reduce the  quantity of loans available to borrowers. Similar results were obtained  when we applied the alternative scenarios to various segments of the  credit market.
The total capital that the four exempt holding companies would need to  raise to meet the same capital standards as their domestic counterparts is  small relative to the total capital in the U.S. banking sector, thus limiting  the effect on the cost and availability of credit. Of the four exempt holding  companies remaining at the end of 2010, three have indicated they might  undertake actions to comply with the minimum capital standards. As table  4 shows, to be considered as meeting the minimum capital requirements  under the Dodd-Frank Act, the three exempt holding companies  collectively would need $3.2 billion in additional capital, only $530 million  of which would need to be in the form of tier 1 common equity to meet the  leverage ratio requirement. This amount is less than 0.21 percent of the  approximate $1.5 trillion in total equity outstanding for the U.S. banking  sector. Two of the exempt holding companies have sufficient tier 1 capital  and would be able to meet the total capital requirement by raising  cheaper supplementary capital. If the exempt holding companies  decided to exceed the minimum requirements and meet the equivalent of  the well-capitalized requirements for banks and thrifts, the difference,  $6.6 billion, would be less than 0.44 percent of the total equity  outstanding. Although this is a sizable capital deficit at the individual  holding company level, it would represent a small shock to the aggregate  U.S. banking sector.
The remaining exempt holding company (company 4, in table 4) would be  significantly below the new minimum capital requirements, with a capital  shortfall of over $21.5 billion. However, domestic loans make up 11  percent of its total assets, while its broker-dealer operations are much  larger. Therefore, maintaining a holding company designation, which  creates a significant capital requirement on its entire asset pool, appears  unlikely. As discussed earlier, the company has stated that it has been  considering a variety of options, including restructuring. A restructuring  may reduce the consolidated capital requirements applied to the foreign  holding company and thus mitigate the need to raise capital to meet the  new minimum capital requirements.
See appendix II for further discussion of the effects of reducing assets on the availability  of credit. variables to shocks to bank capital.any particular manner of adjustment by the holding companies but  focuses on the ultimate impact on loan volumes and spreads.
The methodology does not assume  Although the econometric model we developed indicates that stronger  capital requirements negatively affect lending activity, the impacts at the  aggregate level are small. We evaluated the impact of the new  requirements using two scenarios—exempt holding companies  experienced a capital deficit when compared with the (1) minimum capital  requirements under the Dodd-Frank Act or (2) the well-capitalized  standard that applies to banks and thrifts. Specifically, our model  suggests the elimination of the capital exemption would lead aggregate  loan volumes to decline by roughly 0.2 percent even if the affected  exempt holding companies desired to meet the equivalent of the well- capitalized standard (see table 5). If the affected banks desired to meet  the minimum capital requirements under the Dodd-Frank Act, loan  volumes would decline by less than 0.1 percent. Because the exempt  holding companies would face capital deficits, the impact on the affected  banks could be significant and would vary with the degree of  undercapitalization. For example, loan growth would decline by 5.0  percentage points at company 1, 6.6 percentage points at company 2,  and 7.9 percentage points at company 3 if the targeted total capital ratio  was 10 percent under the well-capitalized standard, and total loan  volumes would fall by $14.2 billion, or 0.2 percent of total loans for the  banking sector. If the affected banks’ targeted total capital ratio was 8  percent (that is, the minimum capital requirement), our model suggests  total loan growth at the three banks would decline by $6.8 billion, or 0.09   However, these estimates  percent of total loans for the banking sector.may overstate the impact on aggregate loan volumes because we  assume no transition period for adjusting to the higher capital  requirements and that other banks do not immediately replace the decline  in loan volumes at the affected institutions.
Because the capital exemption affects only a few institutions operating in  highly competitive loan markets, the impact on the cost of credit, although  uncertain, is likely to be small. Our model suggests that a capital shock  equivalent to that implied by the elimination of the capital exemption  (small at the aggregate level) would lead to an industrywide increase in  lending spreads of a little over 1 basis point (0.01 percentage points). If the exempt companies were measured against the minimum capital  requirements, the impact on lending spreads would be less than 1 basis  point. However, because the elimination would not result in a general  shock across all banks, whether any impact on lending rates would be felt  at the aggregate level is unclear. The competitive nature of loan markets  makes passing on the higher cost of holding more capital to borrowers in  the form of higher loan rates difficult for a bank experiencing a firm- specific capital shock. Because the loan markets are not highly  concentrated and are competitive (as discussed earlier), the affected  exempt holding companies likely would lose business to other banks if  they chose to increase loan rates significantly. Some studies have found  evidence of a relationship between higher capital holdings and market  share during and following banking crises. To avoid losing business to  well-capitalized institutions, the affected holding companies likely would  reduce the amount of risky assets to some extent or undertake other  actions rather than attempting to pass the full cost of holding additional  capital to select customers. Appendix II contains more information on our  analysis of these types of scenarios.
In general, our results for loan volumes and cost and availability of credit  should be interpreted with caution because of the methodological and  other limitations associated with our approach. For example, our  estimates have wide confidence intervals suggesting considerable  uncertainty in the results (see app. I for limitations). As such, considering  our results in the context of a wider body of empirical literature is useful.  Table 5 also includes the average impact on loan volumes and lending  rates based on other studies combined with our calculation of the capital  deficit stemming from the elimination of the capital exemption. The results from our model, although larger for both loan growth and lending  spreads, are consistent with the average we calculated from a number of  empirical studies examining the relationship between bank capital and  lending activity. These studies represent a variety of methodologies, each  with its own limitations. Nevertheless, even the largest estimate we  identified in the literature still would imply a relatively small impact of the  exemption on credit markets.
Particular segments of the market may be affected more than others. For  example, customers in agricultural real estate and agricultural production  loan markets may experience impacts larger than those suggested by the  aggregate analysis. Similarly, two of the exempt holding companies have  a significant presence in the western states, while another has a  significant presence on the East Coast. While the impact on the price and  quantity of credit available may vary across regions, modeling limitations  restrict our ability to estimate potential regional differences. Such regional  impacts should be mitigated to a significant extent by the national nature  of many loan markets. This analysis becomes much more complicated  and uncertain once consideration is given to the impact of the various  provisions of the Dodd-Frank Act and Basel III, which may result in a  large number of institutions looking to replace and raise capital if banks  seek to exceed the new regulatory minimums by the same margin they  exceed them now. However, our results indicate that the elimination of  the capital exemption would add minimally, if at all, to the cumulative  economic impacts of these regulations.
section_title: Market Participants Concerned about Differing Capital Regimes and Competitive Effects Abroad
paragraphs: Market participants expressed uncertainty about how changes in capital  requirements might affect the competitiveness of U.S. banks operating  abroad, partly because the international regulatory landscape remains  unsettled. The largest internationally active U.S. banks derive a significant  portion of their revenues from their operations abroad and are subject to  multiple regulatory regimes. Regulatory capital requirements have  become more stringent globally with the goal of reducing bank failures  and creating a more stable financial system. However, bank officials we  contacted were uncertain how changes in capital requirements might  affect their competitiveness abroad and were monitoring U.S. and  international reforms closely to assess any impact on their cost of capital,  lending ability, and business competitiveness. They were concerned that  fragmented or conflicting regulations might restrict banks’ ability to use  capital efficiently. Some U.S. banks believed that they might be at a  competitive disadvantage to the extent that U.S. banks would be subject  to higher capital requirements than banks from other countries. Finally, as  major regulatory changes stemming from the Dodd-Frank Act, Basel III,  and country-specific reforms are finalized and implemented, many U.S.  bank officials we interviewed expressed concerns about the added costs  of compliance with multiple regulatory regimes.
subsections: section_title: The Largest Internationally Active U.S. Banks Derive Significant Revenues from International Operations
paragraphs: The largest internationally active U.S. banks maintained a strong  presence in major foreign markets, where they derived close to one-third  of their revenues on average in 2010 (see fig. 3). One of the largest  internationally active U.S. banks derived close to 60 percent of its total  revenues from foreign operations in 2010. In the last 3 years, revenues  from foreign operations, although varying by bank and geographical  region, have decreased slightly on a percentage basis.
Generally, the largest internationally active U.S. banks divide their  operations into the following four geographical regions: (1) North America;  (2) Europe, the Middle East, and Africa; (3) Asia or Asia/Pacific; and (4)  Latin America or Latin America/Caribbean. As figure 4 shows, Europe,  the Middle East, and Africa provided the biggest share (about 50 percent)  of all foreign revenues. Revenues from the Asian and Pacific countries  accounted for about 30 percent of foreign revenues compared with  approximately 19 percent from Latin America.
The large internationally active U.S. banks compete with large foreign- based banks and other internationally active U.S. banks across various  product and geographic markets. Internationally active U.S. banks have  varying lines of business. Although some focus on wholesale activities,  one (Citigroup) is engaged in retail banking activities in more than 100  countries. In wholesale markets, some U.S. banks, like JPMorgan Chase  and Bank of America, are active in making commercial and industrial  loans, while others, like Goldman Sachs and Morgan Stanley, hold a  larger percentage of their assets as trading assets and engage in market  making and trading in securities and derivative instruments. One of the  largest internationally active U.S. banks, Bank of New York Mellon,  primarily provides custody and asset management services and securities  servicing. In this capacity, it competes with the largest U.S. banks and  foreign-based banks that provide trust as well as banking and brokerage  services to high-net-worth clients.
section_title: Internationally Active U.S. Banks Will Face Stricter Capital Regimes in Multiple Jurisdictions
paragraphs: In the wake of the 2007-2009 financial crisis, international jurisdictions  have pursued more stringent capital requirements, and large,  internationally active U.S. banks will be subject to the regulatory  requirements of various foreign regulators. For example, in Europe, large  internationally active U.S. banks will be subject to major new regulations,  including those created by the Basel Committee and the European  Commission. The G-20 countries, which include the United States,  adopted the Basel III agreements in November 2010, and the individual  countries are responsible for incorporating the new agreements into  national laws and regulations.
On July 20, 2011, the European Commission published a legislative  proposal known generally as Capital Requirement Directive 4 (CRD4) to  implement the proposals of Basel III into European Union law. The  commission staff we spoke with indicated that there are many legislative  initiatives at the European Union level that could affect U.S.  internationally active banks operating in Europe, but some key ones, in  addition to CRD4, are the Capital Requirement Directive 3 (CRD3) and  the Crisis Management Directive. CRD3 puts in place stricter capital  requirements, some of which became effective at the end of 2011.  Among other things, CRD3 requires banks to implement remuneration  policies that are consistent with their long-term financial results and do  not encourage excessive risk taking. For example, at least 40 percent of  bonuses must be deferred 3-5 years and at least 50 percent must consist  of equity or equity-like instruments or long-dated instruments that are  convertible into tier 1 capital during emergency situations. The Crisis  Management Directive will set out the different tools for resolutions of  bank failures in Europe. It principally aims to provide the authorities with  tools and powers to intervene in banks at a sufficiently early stage and is  due to be adopted formally in November 2011. This resolution authority  also will apply to the European subsidiaries of U.S. banks.
In addition to the European Union regulatory initiatives, individual  countries plan to implement additional measures. For example, the United  Kingdom (UK) independently introduced a permanent levy on banks’  balance sheets on January 1, 2011, to encourage banks to move to less- risky funding profiles, according to the UK’s Her Majesty’s Treasury. The  levy applies to some UK banks, building societies, and UK operations of  foreign banks with more than £20 billion in liabilities. The rate for 2011 will  be 0.05 percent, and it will rise to 0.075 percent in 2012. In June 2010,  France and Germany agreed to similar measures and have been  enacting them.
section_title: Differing International Regulations Could Affect U.S. Banks’ Competitiveness Abroad
paragraphs: U.S. financial regulators and market participants have expressed concern  about the extent to which the capital requirements and other financial  regulations resulting from Basel III could be harmonized across national  jurisdictions and how consistently they would be enforced. For example,  U.S. regulators noted that the supervisory standard for how banks  measure risk-weighted assets—the basis for regulatory capital ratios— under Basel III could be more transparent. In June 2011, the FDIC  Chairman stated that European banks continued to in effect set their own  capital requirements using banks’ internal risk estimates—with risk-based  capital determined by bank management assumptions, unconstrained by  any objective hard limits and no leverage constraints. Other, foreign  regulators also stated that international differences in the calculation of  risk-weighted assets could result from assigning inconsistent risk weights  on the same types of assets and could undermine Basel III. Some foreign  banks we interviewed told us that comparing risk-weighted assets across  banks was challenging because of differing reporting, legal, and  accounting frameworks. For example, comparisons of institutions from the  United States with those from the European Union are difficult because  U.S. banks still are transitioning from Basel I to Basel II and do not  publicly report Basel II risk-based capital requirements. Conversely,  banks in the European Union are operating under Basel II and are  publicly reporting their risk-based capital ratios.
Additionally, U.S. regulators noted the potential for adverse competitive  effects on banks with overseas operations from a Basel III provision for  reciprocal countercyclical buffers. “excessive credit growth” declaration (that is, identifies a “bubble” when  excess aggregate credit growth is judged to be associated with a buildup  of systemwide risk), then all banks operating in that country would have to  meet higher capital requirements. Regulators in other countries also could  require banks operating in their countries to hold proportionately higher  capital. For example, a U.S. bank operating in multiple countries would be  subject to the cumulative effect of each country’s additional requirements  in times of excess aggregate credit growth, and U.S. banking regulators  would have no say over these declarations.
The Basel Committee has expressed concern that the financial regulatory framework did  not provide adequate incentives for firms to mitigate their procyclical use of leverage  (debt). That is, firms tended to increase leverage in strong markets and decrease it when  market conditions deteriorated, amplifying business cycle fluctuations and exacerbating  financial instability. According to regulators, many financial institutions did not increase  regulatory capital and other loss-absorbing buffers during the market upswing, when it  would have been easier and less costly to do so. The Basel III countercyclical buffers are  intended to help address concerns about procyclicality.
However, other factors may help ease concerns about inconsistent  implementation of financial regulations. U.S. regulatory officials have  observed that a high level of coordination among international regulators  would help ensure that banks hold significantly more capital, that the  capital will truly be able to absorb losses of a magnitude associated with  the crisis without recourse to taxpayer support, and that the level and  definition of capital will be uniform across borders. In addition, the  quantity and quality of capital held by the largest internationally active  U.S. and foreign banks has increased significantly in the past few years.  Specifically, among the 50 largest global banks, tier 1 capital adequacy  ratios have climbed from 8.1 percent in 2007 to 11.3 percent at the end of  2010. Since the end of 2008, the 19 largest bank holding companies in  the United States that were subjected to stress tests increased common  equity by more than $300 billion. Furthermore, European banks raised  $121 billion in capital since Europe’s June 2010 stress test exercise.
In addition to the specific concerns related to the implementation of Basel  III, both U.S. and foreign bank officials we interviewed told us that they  were concerned that fragmented or conflicting regulations in the United  States and other jurisdictions might restrict banks’ ability to use capital  efficiently. According to U.S. and foreign bank officials, inconsistent  capital requirements among multiple regulatory regimes may restrict  banks’ ability to move capital across jurisdictions. For example, according  to regulators and U.S. banks we interviewed, since the 2007-2009  financial crisis, foreign regulators have become more sensitive to how  much capital foreign entities in their jurisdiction hold. Some foreign bank  regulators have required banks to “ring fence” capital on the balance  sheet as a way to protect and hold dedicated capital for that bank  subsidiary in their legal jurisdiction in case of financial difficulties or  bankruptcy. Foreign bank regulators were concerned that the parent  company would reallocate capital in their jurisdiction to fund the parent  company located outside of their jurisdiction, potentially resulting in the  subsidiary being undercapitalized. According to some banks we  interviewed ring fencing would be costly for banks operating abroad as it  restricts capital and requires systems for keeping operations segregated  across countries.
In another example, U.S. bank officials noted that recent reforms have  changed what types of capital instruments can be counted as tier 1  capital. As a result, U.S. banks may not have access to tax-efficient tier 1  instruments that foreign bank competitors can issue because of  differences in national tax policies. Specifically, prior to the recent  changes under the Dodd-Frank Act and Basel III, U.S. bank holding  companies could issue tier 1 trust-preferred securities with dividend  payments that were tax-deductible. With the exclusion of trust-preferred  securities from tier 1, large internationally active banks likely will not have  any tax-efficient alternative in the United States, while foreign banks in  certain jurisdictions will continue to have access to certain capital  instruments, such as noncumulative perpetual preferred shares, that  confer some tax benefits because of local tax laws.
As major regulatory changes stemming from the Dodd-Frank Act, Basel  III, and country-specific reforms are finalized and implemented, many  U.S. and foreign bank officials we interviewed expressed concerns about  the added costs of compliance with multiple regulatory regimes. Because  these regulations have not been implemented yet, how they may affect  the operations of U.S. banks abroad is not known. For example,  according to U.S. bank officials, they cannot yet estimate the cost  associated with implementing and complying with the new risk-based  capital and leverage requirements under Basel III. Moreover,  implementation of key provisions of the Dodd-Frank Act and the new  Basel III capital and liquidity requirements will be particularly challenging  because of the number of related provisions that must be considered  together. According to a testimony given by the Acting Comptroller of  OCC, regulators have been trying to understand not only how individual  provisions will affect the international competitiveness of U.S. firms, but  also how the interactions of the various requirements of the Dodd-Frank  Act and Basel III will affect U.S. firms domestically.
According to testimony from an industry expert, areas other than the bank  capital provisions of the Dodd-Frank Act can affect costs (including  compliance costs and competition): prohibition of proprietary trading by  banks, exclusion of the use of external credit ratings for determining risk  weighting, regulations governing derivatives, the designation and  regulation of SIFIs, and resolution of insolvent financial firms. For example, bank officials we interviewed told us that the Dodd-Frank Act’s  exclusion of the use of external credit ratings for determining risk  weighting will create additional costs to U.S. banks. The banks would  have to develop their own methods for performing these calculations,  potentially putting them at a competitive disadvantage (including higher  cost) internationally because European banks could still use such credit  ratings, which are widely understood and used by investors. U.S. bank  officials also noted that they would incur increased administrative costs  under multiple regulatory regimes as they would have to implement and  comply with multiple capital ratios, including those for the U.S. and foreign  jurisdictions. Many U.S. banks GAO interviewed expressed concerns  about the added costs of compliance with multiple regulatory regimes and  the impact of the Dodd-Frank Act on the global competitiveness of U.S.  banks, but these concerns would need to be considered against the  potential benefits of a safer and sounder financial system.
section_title: Agency Comments
paragraphs: We provided a draft of this report to the FDIC, the Federal Reserve and  OCC for their review and comment. Each of the federal banking  regulators provided technical comments that were incorporated in the  report, as appropriate.
We are sending copies of this report to appropriate congressional  committees, FDIC, the Federal Reserve, OCC, and the Department of the  Treasury, and other interested parties. In addition, the report is available  at no charge on the GAO website at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (202) 512-2642 or mccoolt@gao.gov. Contact points for our Offices  of Congressional Relations and Public Affairs may be found on the last  page of this report. GAO staff who made key contributions to this report  are listed in appendix VI.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: The objectives of the report were to examine (1) the regulation of foreign- owned intermediate holding companies in the United States, (2) the  potential effects of changes in U.S. capital requirements on foreign- owned intermediate holding companies, and (3) banks’ views on the  potential effects of changes in U.S. capital requirements on U.S.-owned  banks operating abroad. This report focuses on intermediate holding  companies owned by a foreign parent bank (that is, a foreign banking  organization) and the largest internationally active U.S. banks based on  their level of foreign business activity. The foreign parent bank may have  its U.S. subsidiaries owned or controlled by an intermediate bank or thrift  holding company in the United States (the organization between the  subsidiary bank and the foreign parent bank) primarily to take advantage  of tax or regulatory benefits. Under this corporate structure, the  intermediate holding company represents the foreign parent bank’s top- tiered legal entity in the United States and is regulated by the Board of  Governors of the Federal Reserve System (Federal Reserve).
To describe how foreign holding companies are regulated and supervised  in the United States, we reviewed relevant federal and state banking laws  and regulations (such as the International Banking Act of 1978, Foreign  Bank Supervision Enhancement Act of 1991, section 171 of the Dodd- Frank Wall Street Reform and Consumer Protection Act ,  and New York state banking law). We reviewed regulatory documents such  as the Federal Reserve’s Consolidated Financial Statements for Bank  Holding Companies—FR Y-9C. Further, we reviewed supervisory guidance such as Supervision and Regulation Letter 01-1 (the capital  exemption), the final rule that establishes a floor for the risk-based capital  requirements applicable to the largest internationally active banks, relevant  published reports, testimonies, speeches, articles, and relevant prior GAO  reports. We interviewed supervisory officials at the Federal Reserve,  Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of  the Currency (OCC), Office of Thrift Supervision (OTS), New York State  Banking Department, and officials at the Department of the Treasury, the  European Commission (a European Union entity that, among other things,  through capital directives sets out general capital rules to be transferred  into national law by each of the 27 European Union countries as they deem  appropriate), foreign and U.S. bank holding companies, a foreign trade  association, credit rating agencies, and law firms. In addition, we received  written responses to questions from the European Banking Authority  (European banking regulator) and attended a conference on the  implications of new capital rules for foreign banks.
To assess the potential effects of changes in capital requirements for  foreign-owned intermediate holding companies, we reviewed section 171  of the Dodd-Frank Act, and proposed and final capital rules for foreign- owned intermediate holding companies and related comment letters. We  reviewed various proposed and final international capital rules. We  reviewed Securities and Exchange Commission (SEC) regulatory filings  of foreign bank holding companies. We interviewed foreign bank  regulators, foreign and U.S. bank holding companies, credit rating  agencies, and industry experts on the effects of the new capital  requirements on foreign banks operating in the United States. We also  reviewed academic studies on the impact of higher capital requirements  on the cost of capital and lending and obtained the views of foreign and  domestic banks, credit rating agencies, and industry experts.
To assess the extent to which credit markets are likely to be affected by  removal of the capital exemption, we calculated market shares for each  group of bank holding companies in loan markets as of December 31,  2010. We obtained balance sheet data for bank holding companies as of  December 31, 2010, from SNL Financial, which reports data for bank  holding companies based on forms FR Y-9C submitted to the Federal  Reserve. In general, only top-tier bank holding companies with  consolidated assets of $500 million or more are required to submit FR Y- 9Cs. To avoid double-counting bank holding companies that are  subsidiaries of other bank holding companies, we obtained lists of  second-tier bank holding companies as of December 31, 2010, from the  Federal Reserve’s National Information Center website and used this list  to drop any second-tier bank holding companies from our analysis. Our  sample—our definition of the market—is thus the collection of top-tier  bank holding companies with consolidated assets of $500 million or more  that filed FR Y-9Cs with the Federal Reserve as of December 31, 2010.
We obtained lists of all top-tier foreign-owned intermediate holding  companies—both exempt and nonexempt—operating in the United States  as of December 31, 2010, from the Federal Reserve. We used these lists  to classify bank holding companies in our sample as one of three types:  exempt foreign-owned intermediate holding companies, nonexempt  foreign-owned intermediate holding companies, and U.S. bank holding  companies. We calculated the percentage of various types of loans on  the balance sheets of each group, including the following:  total domestic loans and leases, nonresidential construction loans and all land development and other  land loans, agricultural real estate loans, home equity lines of credit,  first-lien residential mortgage loans, junior-lien residential mortgage loans, multifamily residential property loans, owner-occupied commercial real estate loans, nonowner-occupied commercial real estate loans, agricultural production loans,  commercial and industrial loans, leases.
We used amounts reported for domestic offices only so that our  comparisons were consistent across foreign-owned intermediate holding  companies and U.S. bank holding companies. A group’s market share is  the total dollar value of loans on the balance sheets of all bank holding  companies in the group as a percentage of the total dollar value of loans  on the balance sheets of all bank holding companies in the market.
To assess the extent to which the price of credit and the quantity of credit  available are likely to be affected because of the removal of the capital  exemption, we used the used the HHI to measure market concentration.  The HHI is a key statistical indicator used to assess the market  concentration and the potential for firms to exercise market power. The  HHI reflects the number of firms in the market and each firm’s market  share, and it is calculated by summing the squares of the market shares  of each firm in the market. For example, a market consisting of four firms  with market shares of 30 percent, 30 percent, 20 percent, and 20 percent  has an HHI of 2,600 (900 + 900 + 400 + 400 = 2,600). The HHI ranges  from 10,000 (if there is a single firm in the market) to a number  approaching 0 (in the case of a perfectly competitive market). That is,  higher values of the HHI indicate a more concentrated market.  Department of Justice and Federal Trade Commission guidelines as of  August 19, 2010, suggest that an HHI between 0 and 1,500 indicates that  a market is not concentrated, an HHI between 1,500 and 2,500 indicates  that a market is moderately concentrated, and an HHI greater than 2,500  indicates that a market is highly concentrated, although other factors also  play a role in determining market concentration.
We calculated the HHI for 2010 for each of the loan markets listed above.  Each bank holding company is a separate firm in the market, and its  market share is equal to the dollar value of loans on its balance sheet as  a percentage of the total dollar value of loans on the balance sheets of all  the bank holding companies in the market.
We also calculated the HHI for 2010 for each loan market in alternative  scenarios in which exempt holding companies cease making loans and  transfer the loans on their balance sheets to bank holding companies that  remain in the market. In the first scenario, exempt foreign-owned  intermediate holding companies’ loans are distributed proportionally  among remaining bank holding companies. In the second scenario,  exempt foreign-owned intermediate holding companies’ loans are  acquired by the largest remaining bank holding company in the market.
A limitation of defining the market as the collection of top-tier bank holding  companies that filed FR Y-9Cs with the Federal Reserve is that we  exclude organizations that provide credit. For example, small bank  holding companies—those with consolidated assets of less than $500  million—generally are not required to file form FR Y-9C. However, they do  make loans. Other credit market participants include savings and loan  holding companies, stand alone banks, savings and loan associations,  credit unions, and finance companies not owned by bank holding  companies. Capital markets are another source of funds for some  borrowers. As a result, our estimates of market shares are likely  overstated. Furthermore, our estimates of market concentration may be  either understated or overstated, depending on the number and market  shares of other credit providers.
Another limitation of our analysis is that we implicitly assume that all loan  markets are national in scope; that is, that credit provided by a bank  holding company is available to any potential borrower, regardless of his  or her respective geographic location. If loan markets are not national in  scope, then our market share and market concentration estimates are  unlikely to represent those that we would estimate for a specific  subnational region, such as a state or metropolitan area. The market  share and market concentration estimates for some regions likely would  be greater than our national estimates, while others likely would be lower.
For this analysis, we relied on the Federal Reserve’s FY-9C data that we  obtained through SNL Financial and on information from the Federal  Reserve on foreign banking organizations’ top-tier intermediate holding  companies in the United States. We conducted reliability assessment on  these data by reviewing factors such as timeliness, accuracy, and  completeness. We also conducted electronic testing to identify missing and  out-of-range data. Where applicable, we contacted officials from the Federal  Reserve to address questions about the reliability of the information. We  found the data to be sufficiently reliable for our purposes.
To estimate the effect of capital ratios on the cost and availability of  credit, we estimated a modified version of a vector autoregression (VAR)  model commonly used in the macroeconomics and monetary literature.  Our model closely follows Berrospide and Edge (2010) and Lown and  Morgan (2006). The VAR consists of eight variables. The core variables  that represent the macroeconomy are (1) real gross domestic product  (GDP) growth, (2) GDP price inflation, (3) federal funds rate, and (4)  commodity price index growth. As is pointed out in Lown and Morgan  (2006), these four variables potentially make up a complete economy,  with output, price, demand, and supply all represented. We capture the  banking sector with four variables: (1) loan volume growth, (2) changes in  lending spreads—commercial and industrial loan rates relative to a  benchmark, (3) lending standards as measured by the net fraction of loan  officers at commercial banks reporting a tightening of credit standards for  commercial and industrial loans in the Federal Reserve’s Senior Loan  Officer Opinion Survey, and (4) the aggregate capital-to-assets ratio for  the commercial bank sector. The addition of the latter four variables  allows us to investigate the dynamic interaction between banks and the  macroeconomy. The data were assembled from Thomson-Reuters  Datastream and the Federal Reserve. We have relied on these data in  our past reports and consider them to be reliable for our purposes here.
Using the estimated VAR system for the third quarter of 1990 to the  second quarter of 2010, we trace the dynamic responses of loan  volumes, lending spreads, and other macroeconomic variables to shocks  to the bank capital ratio. As a result, we can obtain quantitative estimates  of how bank “innovations” or “shocks” affect the cost and availability of  credit. Our base results rely on impulse response functions using the  following causal ordering of the variables: GDP, inflation, federal funds  rate, commodity spot prices, loan volumes, capital ratio, loan spreads,  and lending standards. However, our final estimates use the average of  the outcomes for the two different orderings of the variables: (1) where  the macro variables are given causal priority and (2) where the bank  variables are given causal priority. The VAR model, and the innovation  accounting framework, is laid out in greater detail in another GAO report.
The VAR methodology, while containing some advantages over other  modeling techniques, has particular limitations, and therefore the results  should be interpreted with caution. First, the methodology potentially  overstates the quantitative effects of shocks on the economy and can be  difficult to interpret. Second, because the technique relies on past data, it  is subject to the criticism that past information may not be useful for  gauging future response due to policy changes. Third, to conduct  meaningful assessments of the impacts of shocks to the system, causal  priority is given to some variables over others. However, our results are  not particularly sensitive to this ordering, although we do obtain smaller  impacts of bank capital on lending activity with some alternative  orderings. To minimize this limitation, our estimates are an average of a  model where causal priority is given to the macroeconomic variables and  a model where causal priority is given to the bank variables. Last, in our  particular case the impulse response functions have wide confidence  intervals, suggesting considerable uncertainty in the results. Despite  these limitations, the VAR approach is considered to be a reasonable  alternative to other types of models. However, it is prudent to evaluate our  results in the context of the wider body of research on the effects of bank  capital on lending activity.
The studies we relied on for comparison are useful in that they represent  a variety of different modeling techniques ranging from VAR and cross- sectional regression methodologies to more sophisticated dynamic  stochastic general equilibrium (DSGE) modeling. None of these  approaches are without limitations. For example DSGE models, although  among the best for conducting counterfactual experiments and easy to  interpret, are difficult to estimate and the techniques used to facilitate  estimation can result in questionable results that are at odds with  empirical observations. Nevertheless, by considering the body of  evidence from different studies, we are able to provide some assessment  of the reliability of our findings. However, the studies discussed in the  report are included solely for research purposes and our reference to  them does not imply we find them definitive.
To describe U.S. banks operating abroad and their services, major  customers, and competitors, we used information obtained from interviews  with some of the largest internationally active U.S. banks. We also  analyzed audited financial statements in the annual reports for relevant  companies. We selected the six largest internationally active U.S. banks  based on their level of foreign business activity. To identify banks’ views  on the potential risks from changes in capital requirements on U.S. banks  operating abroad, we interviewed officials from the three U.S. bank holding  companies that engaged in significant international operations. We also  interviewed officials from the European Commission—a European Union  entity that, among other things, through capital directives sets out general  capital rules to be transferred into national law by each of the 27 European  Union countries as they deem appropriate. We summarized relevant  academic literature and regulatory studies and congressional testimonies  on the potential effects on U.S. banks’ funding costs, product pricing, and  lending activity abroad. We also obtained the views of federal banking  officials from the Federal Reserve, FDIC, OCC, and OTS, and officials from  the Department of the Treasury.
We conducted this performance audit from December 2010 to January  2012 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
section_title: Appendix II: Impact of Reducing the Risk-Weighted Assets of Exempt Holding Companies to Comply with New Requirements
paragraphs: Bank holding companies can take different approaches to comply with the  new capital requirement in the Dodd-Frank Wall Street Reform and  Consumer Protection Act. From 2001 to 2010, the Board of Governors of  the Federal Reserve System granted capital requirement exemptions to  six foreign-owned intermediate holding companies provided that the  companies satisfied certain conditions, including having well-capitalized  foreign parent banks. As of the end of 2010, four foreign-owned  intermediate holding companies continued to rely on a capital exemption  from the Federal Reserve. The Dodd-Frank Act eliminated this  exemption, and these exempt holding companies must now meet new  capital requirements. Some of these exempt holding companies may  choose to raise capital, while others may choose to deleverage by  decreasing the risk-weighted assets on their balance sheets (or a  combination thereof). Although predicting the responses of the exempt  holding companies to the higher U.S. bank capital requirements is a  complex proposition, this appendix illustrates the potential effect on the  availability of credit if the three exempt holding companies respond by  reducing their balance sheets.
If the exempt holding companies chose to reduce their balance sheets to  meet new capital regulations, we estimate that the decrease would be  small relative to the aggregate assets for the U.S. banking sector. As  table 6 illustrates, the three exempt holding companies would need to  decrease their risk-weighted assets by amounts ranging from $12.2 billion  to as much as $15.3 billion to meet the minimum capital requirements  under the Dodd-Frank Act.at the individual holding company level, it is small as a percentage of the  total risk-weighted assets of the U.S. banking sector (see table 6). For  example, although the exempt holding companies would have to reduce  their balance sheets by 20 percent on average, the total decline in assets  amounts to 0.44 percent of the $9.1 trillion in total risk-weighted assets for  the aggregate U.S. banking sector. To meet the equivalent of the well- capitalized standards that apply to banks and thrifts, the exempt holding  companies would need to reduce their risk-weighted assets by $65.8  billion, or roughly 0.7 percent of the total risk-weighted assets for the  aggregate U.S. banking sector. This would require two of the exempt  holding companies to decrease risk-weighted assets by roughly 38  percent and 34 percent, respectively.
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact listed above, Daniel Garcia-Diaz (Acting  Director), Rachel DeMarcus, M’Baye Diagne, Lawrance Evans Jr., Colin  Gray, Joe Hunter, Elizabeth Jimenez, Courtney LaFountain, Akiko  Ohnuma, Marc Molino, Timothy Mooney, Patricia Moye, Michael Pahr,  and Barbara Roesmann made key contributions to this report.