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

Letter

Background

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.

Organization of Foreign Banks in the United States

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.

International Efforts to Enhance Bank Supervision and Stability of the Financial System

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.

U.S. Regulation of Foreign-Owned Holding Companies Intended to Achieve Equivalency with Domestic Counterparts

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.

U.S. Regulatory Reform Eliminated Capital Exemption for Certain Intermediate Holding Companies

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.

Stricter Capital Adequacy Standards Also Will Apply to Foreign and U.S. Holding Companies

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.

Overall Effects of Capital Changes for Exempt Foreign- owned Intermediate Holding Companies Likely to Be Limited

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.

Foreign Parent Banks May Restructure or Take Other Actions to Comply with New Requirements

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.

Eliminating the Exemption Likely Will Have Limited Effects on Overall Competition and Credit

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.

Market Participants Concerned about Differing Capital Regimes and Competitive Effects Abroad

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.

The Largest Internationally Active U.S. Banks Derive Significant Revenues from International Operations

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.

Internationally Active U.S. Banks Will Face Stricter Capital Regimes in Multiple Jurisdictions

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.

Differing International Regulations Could Affect U.S. Banks’ Competitiveness Abroad

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.

Agency Comments

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.

Appendix I: Objectives, Scope, and Methodology

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.

Appendix II: Impact of Reducing the Risk-Weighted Assets of Exempt Holding Companies to Comply with New Requirements

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.

Appendix III: GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

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.