Regulating Large Foreign Banking Organizations
Targeted News Service |
The financial crisis exposed, in painful and dramatic fashion, the shortcomings of existing regulatory and supervisory regimes. In both
Let me note at the outset the now commonplace observation that we have a quite integrated international financial system, with many large, globally active firms operating within a system of national government and regulation or, in the case of the EU, a hybrid of regional and national regulation. I add the equally commonplace observation that there is no realistic prospect for having a global banking regulator and, consequently, the responsibility and authority for financial stability will continue to rest with national or regional authorities.1 The question, then, is how responsibility for oversight of these large firms can be most effectively shared among regulators. This, of course, is the important issue underlying the perennial challenge of home-host supervisory relations.
Another introductory observation is that--at least in a world of nations with substantially different economic circumstances, different currencies, and banking and capital markets of quite different levels of depth and development--there will be good reason to vary at least some forms of regulation across countries. Presumptively, at least, nations should be able to adjust their regulatory systems based on local circumstances and their relative level of risk aversion as it pertains to the potential for financial instability. Although the financial systems and economies of
These opening observations are important in responding to the curious charge of "Balkanization" that has been levelled at
In the rest of my remarks I will elaborate on these points, though not in the spirit of a debater's arguments, but in an effort to answer the question I posed a moment ago: How, that is, can we successfully reduce the risks to financial stability posed by large, internationally active banks? As I hope will become apparent, a theme I wish to emphasize is that we need to redouble efforts at genuine supervisory cooperation if we are to manage effectively the vulnerabilities and challenges posed by the perennial home-host issue.
International Principles on Home- and Host-Country Responsibilities While the circumstances and risks may have changed, the issue of the appropriate roles of home and host countries is not a new one. Indeed, it was a key motivation for creation of the Basel Committee in 1975 following the failures of the Herstatt and Franklin National banks. Many of the Basel Committee's early activities were focused on the challenges created by gaps in the supervision of internationally active banks, as evidenced by the fact that Basel "Concordats" on supervision preceded Basel "Accords" and "Frameworks" on capital and other subjects. This task has, of necessity, been ongoing, as experience revealed gaps in supervisory coverage and as the scale and scope of internationally active banks grew. The principle of consolidated supervision emerged in the early 1980s to ensure that some specific banking authority--generally the home-country regulator--had a complete view of the assets and liabilities of the bank.2 This principle was reinforced and elaborated following the
It is important to note that each Basel Committee declaration on the importance of home-country consolidated oversight has also included a statement of the obligations and prerogatives of host states in which significant foreign bank operations are located. This feature of the Basel Committee's approach makes sense as a reflection both of the host authority's responsibility for stability of its financial system and of the practical point that a host authority will be more familiar with the characteristics and risks in its market. In accordance with this history, the current version of the "Core Principles for Effective Banking Supervision" sets out as one of its "essential criteria" for home-host relationships that "[t]he host supervisor's national laws or regulations require that the cross-border operations of foreign banks are subject to prudential, inspection and regulatory reporting requirements similar to those for domestic banks."4
It is clear, then, that consolidated supervision is not intended to displace host-country supervision. Instead, as the Basel Committee has regularly noted, the two are intended to be complementary, so as to assure effective oversight of large, internationally active banks. Similarly, the stated purpose of the Basel Committee in requiring consolidated capital requirements is not to remove from host countries any responsibility or discretion to apply regulatory capital requirements, but to "preserve the integrity of capital in banks with subsidiaries by eliminating double gearing."5 Likewise, and contrary to suggestions that are sometimes made, the capital accords and frameworks developed by the Basel Committee have always been explicitly minimum requirements. They are floors, not ceilings.
Finally, it is worth noting that, in establishing a post-crisis framework for domestic systemically important banks (D-SIBs), the Basel Committee made clear that a host country may in appropriate circumstances designate domestic operations of a foreign bank as systemically important for that country, even if the parent foreign bank has already been designated a global systemically important bank (G-SIB).6 The idea informing the newly created concept of a D-SIB is that an entity whose stress or failure could destabilize a domestic financial system might thereby indirectly destabilize the international financial system. Thus, the D-SIB category carries along with it higher loss-absorbency requirements than are generally applicable to domestic banks, although perhaps not as high as requirements for G-SIBs. Of course, our regulation for foreign banking organizations (FBOs) does not entail D-SIB designation or require higher than generally applicable loss absorbency. But I cite this feature of the D-SIB framework that permits designation of the domestic operations of foreign G-SIBs because it reflects rather clearly the principle that the specific characteristics of domestic markets may call for regulation of foreign banks in the host country, not just at a consolidated level.
In short, the work of the Basel Committee over the years has not been directed at restraining host-country authorities from supervising and regulating foreign banking operations in their country. On the contrary, the committee has repeatedly asserted the complementary responsibilities of both home and host countries to oversee large, internationally active banking groups, in the interests of both national and international financial stability. And the committee has frequently returned to this set of issues in responding to developments that pose a threat to the safety and soundness of the international financial system.
The Shift in Foreign Bank Activities
Unfortunately, neither the Basel Committee nor national regulators responded in a timely fashion to the magnitude of the expansion in scale and scope of the world's largest banking organizations in the roughly 15 years before the financial crisis. As illustrated in figure 1, at the end of 1974, just before the Basel Committee was created, the assets of the world's 10 largest banking organizations together equaled about 8 percent of global GDP. The three largest were all American--BankAmerica,
Then the explosive growth began. In the next decade--that is, up to the onset of the financial crisis in 2007--the combined assets of the world's 10 largest banks as a share of global GDP nearly tripled, to about 43 percent. The largest bank in the world at that time,
Not only did the size of the largest banks change dramatically, so, too, did their scope, reflecting the overall integration of capital market and traditional lending activities that accelerated in the decade and a half preceding the crisis. This trend was particularly apparent in
Meanwhile, even the traditional branching model of large foreign commercial banks in
A good bit of this short-term funding was used to finance long-term, U.S. dollar-denominated project and trade finance around the world. There is also evidence that a significant portion of the dollars raised by European banks in the pre-crisis period ultimately returned to
Just as regulatory systems did not, in the years preceding the crisis, address vulnerabilities such as reliance on short-term wholesale funding that were created by the integration of capital markets and traditional lending, so they did not respond to the transformation of foreign banking operations. Accordingly, just as home countries of systemically important banks have been playing catch-up on capital, liquidity, and other requirements, so host countries of very large foreign banking operations are playing catch-up in dealing with the very different character of many internationally active banks from that of 20 or 30 years ago.
The Regulatory Response
In a sense, the major strengthening during the past few years of capital and liquidity requirements for internationally active banks--including the capital surcharge for banks of global systemic importance--has to date been the most important international regulatory response to the revealed vulnerabilities associated with large foreign banking operations. Building capital and improving the liquidity positions of banks on a consolidated basis is surely a key step toward assuring the stability of major FBOs in host countries.
Of course, these agreed changes have not yet been fully implemented. It is critical not just that all jurisdictions adopt appropriate regulations that fully incorporate the new
First, though, I want to describe how
The EU has not, since the crisis, specifically adjusted the structure of regulation of foreign banks by its member states in their role as host supervisors. For more than a decade before the crisis, EU member states had prudently required that not only commercial banking, but also investment banking subsidiaries of foreign (non-EU-based) banking organizations, be subject to
Before the crisis and the subsequent development of Basel III, there was no leverage ratio requirement in EU capital directives. Insofar as a new leverage ratio is part of the Basel III package agreed upon internationally, one would anticipate that it will be applied to commercial banking and investment banking firms in the EU, again including local subsidiaries of non-EU firms. Likewise, one would anticipate that the Basel III liquidity requirements will be implemented in the EU in accordance with the internationally agreed timeline and, again, that it will apply to EU subsidiaries of FBOs.
A greater challenge for the EU has been dealing with banks headquartered in one EU country but doing business in other EU countries under the "single passport," which basically allows for full access in the rest of the EU, with supervision provided only by the home country. During the crisis, there were some notable instances of banking stresses and failures involving such institutions, with consequent negative effects on depositors, counterparties, and economies in other parts of the EU. Much of the ongoing post-crisis reform agenda in
As a member state of the EU, the
The
Unlike the EU,
During the crisis, the ill-advised nature of this regulatory state of affairs became apparent. The decline in value of many mortgage-backed securities and the consequent market uncertainty as to the true value of that entire class of securities raised questions about the solvency of major broker-dealers. Because the dealers were so highly leveraged and dependent on short-term financing, the uncertainty also led to serious liquidity strains, first at Bear Stearns and
Through its Primary Dealer Credit Facility, the Federal Reserve provided substantial liquidity to the broker-dealer affiliates of the bank holding companies, as well as to the primary dealer subsidiaries of foreign banks. At the same time, the shift in strategy of many foreign banks toward using their U.S. branches to raise dollars in short-term markets for lending around the world created another set of vulnerabilities that resulted in substantial and, relative to total assets, disproportionate use of the Federal Reserve's discount window by foreign bank branches.
The experience of the crisis made clear, first, that the perimeter of prudential regulation around U.S. financial institutions needed to be expanded. As noted a moment ago, this had occurred de facto during the crisis. The Dodd-Frank Act has given a legal foundation for this change, first by mandating that
Structurally, the U.S. capital requirements for FBOs are similar to those that apply to foreign banks in the EU. That is, generally applicable
The leverage ratio requirement has received particular attention. One complaint is that the foreign operations of U.S. banks are not subject to leverage ratios for their local operations. It is true that many foreign countries--including the EU member states--do not currently have leverage ratio standards for their banks. As noted earlier, however, one may reasonably expect that those countries will be implementing the Basel III leverage ratio in a timely fashion. Also, I would note in passing that the U.S. leverage ratio requirement for foreign firms will be phased in more slowly than originally proposed, so as to align it more closely with the effective date of the Basel III leverage ratio requirement.
A second complaint is that there is something unfair about
The applicable liquidity requirements, while somewhat differently defined, are roughly comparable to those already applicable to FBOs in the
The most notable departure of the new U.S. FBO standards from existing EU and
"Balkanization" and Home-Host Responsibilities To return to the issue of Balkanization, three things should now be apparent. First, in its new capital regulations applicable to FBOs,
Second, there is considerable scope for a foreign bank to integrate its U.S. operations with its global activities within the rule the Federal Reserve adopted last month. For example, while foreign firms with more than
Third, the capital and liquidity requirements that do apply are wholly consistent with the responsibility of host-country supervisors to assure financial stability in their own markets. Collectively, foreign banks with a large presence in
On the issue of home-host-country coordination in regulating large, globally active banking organizations, I would make three additional points. First, our FBO capital requirements, like those of the EU for foreign commercial and investment banks, are based on the capital rules agreed to in the Basel Committee.15 Thus, there is an overall compatibility between national and international rules with respect to applicable definitions, standards, and required ratios.
Second, home countries must implement and enforce faithfully at a consolidated level these same capital rules. More broadly, home-country supervisory expectations for strong consolidated capital levels, liquidity positions, and risk-management practices are likely to facilitate compliance with domestic requirements for large FBOs of the sort applicable in
In this regard, I think that capital requirements for FBOs of the sort now required by the EU and
Third, we--by which I mean both home and major host banking regulators--need to find better ways of fostering genuine regulatory and supervisory cooperation. Particularly at the most senior levels of the agencies that actually supervise globally active banks, our interactions with our counterparts from other countries have become almost exclusively focused on developing international standards or reviewing compliance with existing ones. These discussions are usually conducted with numerous colleagues who are not themselves responsible for banking regulation in their own jurisdictions. As important as these efforts have been, and continue to be, following the crisis, there is a risk that by not having opportunities for senior officials of the various national agencies that have direct supervisory responsibility for banking organizations to meet and discuss shared challenges, we give short shrift to the collective interest of bank regulators in effective supervision of all globally active firms. Proposals to include prudential requirements or, more precisely, to include limitations on prudential requirements in trade agreements would lead us farther away from the aforementioned goal of emphasizing shared financial stability interests, in favor of an approach to prudential matters informed principally by considerations of commercial advantage.
Conclusion
The job of regulating and supervising large, globally active banking organizations is a tough one. Issues of moral hazard, negative externalities, and asymmetric information are, if not pervasive, then at least significant and recurring. The job is made only harder by the fact that these firms cross borders in ways their regulators do not. But we cannot ignore this fact and pretend that we have global oversight. International standards for prudential regulation are not the same as global regulations, and consolidated supervision is not the same as comprehensive supervision. The jurisdictions represented on the Basel Committee not only have the right to regulate their financial markets--including large FBOs participating in those markets--they have a responsibility to their home jurisdictions, and to the rest of the world, to do so. The most important contribution
There must be some assurance beyond mere words from parent banks or home-country supervisors that a large FBO will remain strong or supported in periods of stress. After all, as we saw in the crisis, while a parent bank or home-country authorities may have offered those words with total good faith in calm times, they may be unable to carry through on them in more financially turbulent periods. None of this means that we need be at odds with one another. On the contrary, these very circumstances call not only for more tangible safeguards in host countries, but also for more genuine cooperation among supervisory authorities. Indeed, as I hope will continue to be the case with the international agenda on resolution, total loss absorbency, and related matters, we should aspire to converge around the kinds of protections that we can expect at both consolidated and local levels.
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