The Fed Wants More Protection Against Losses at Foreign Banks’ U.S. Units

The Federal Reserve wants U.S. subsidiaries to have bigger cushions against losses
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The world’s biggest banks paint on a vast canvas. Many operate with a single, global balance sheet, raising money where it’s cheapest and investing it where it earns the highest return. So in certain countries, banks can have more liabilities than assets. Regulators allow them a free hand on the assumption that if one of their national operations runs into trouble, the home office will quickly route it all the funds it needs.

Daniel Tarullo doesn’t think that’s such a good idea. And as the point person for regulation on the Federal Reserve’s Board of Governors, he has sway in saying no. Tarullo is part of a wave of national regulators who are “ring-fencing” national banking operations—insisting that they have a thick cushion of capital locally. The Fed doesn’t want to have to beg other central banks for help if a foreign bank in the U.S. suffers a funding crisis. Goodbye, globalization. Hello, Balkanization.

In December the Fed proposed a rule, shaped by Tarullo, that would require the U.S. units of foreign commercial and investment banks to have assets on their books well in excess of their borrowings as a buffer against losses. They can still lend and invest abroad. But the value of all the subsidiaries’ assets, whether inside or outside the U.S., has to be greater than their liabilities such as bonds, repo borrowings, or bank deposits they’ve taken in.

Although the U.S. wasn’t the first country to propose ring-fencing, the move stirred opposition because the U.S. is a vital market for global banks and, traditionally, a defender of the free flow of money across borders. Michel Barnier, the member of the European Commission who oversees financial services, wrote to Fed Chairman Ben Bernanke earlier this year that the plan could trigger an international backlash and “fragmentation of global banking markets.” What seemed to bother him most was that the Fed didn’t trust its foreign counterparts. “Trust among regulators,” he wrote, is “essential.”

The Fed, which is reviewing public comments on the plan, has given no sign it’s backing down. “I’m a bit bemused by complaints that somehow we are doing something that is a break with what’s been done before,” Tarullo said in a question-and-answer session after a speech in May at the Peterson Institute for International Economics.

Tarullo, 60, is no friend of big banks. Born and raised in Boston, he says that the late Democratic Senator Edward Kennedy was “my first real political mentor.” He’s a former professor at Georgetown University Law Center who held several posts in the Clinton administration and has a wonk’s passion for international financial regulation. In a book published in September 2008, he criticized Basel II, the international accord that let banks use their own risk models to decide how much capital they needed. The financial crisis and its aftermath only heightened his concerns.

In November, Tarullo gave a speech at Yale that presaged the Fed’s proposal on capital requirements for foreign banks the following month. “The likelihood that some home-country governments of significant international firms will backstop their banks’ foreign operations in a crisis appears to have diminished,” Tarullo said. He noted that foreign bank branches had become increasingly reliant on short-term funding (which is riskier, because it can be pulled away abruptly) and had become a conduit for money to leave the U.S. rather than enter it.

Foreign banks and regulators argue that the Fed plan would make it hard for multinational banks to operate globally. In a Wall Street Journal op-ed last spring, Sally Miller, chief executive officer of the Institute of International Bankers, which represents foreign banks operating in the U.S., called it “a glaring violation of long-standing principles of equal national treatment.”

Economists on the staff of the Federal Reserve have documented what looks like genuine harm to the U.S. economy from a 2011 episode in which foreign banks operating in the U.S. were temporarily starved of cash. The Fed economists found that in the spring of 2011, investors began to fret that a Greek default would damage European banks that had lent to Greece. Money-market mutual funds that had lent to the European banks by buying certificates of deposit were forced to cut back their loans because their own customers were withdrawing deposits.

What happened next never made the newspapers. According to the latest version of a working paper by three Fed staff economists, published in July, the European bank branches in the U.S. appealed to their home offices for funds to replace what they’d lost, but they didn’t get all they needed. They were forced to cut back lending in the U.S. by about $20 billion, the working paper said. That’s not a lot in an almost $16 trillion U.S. economy, but to the Fed it was a taste of what might happen in a more serious funding squeeze.

Deutsche Bank, Credit Suisse, and Barclays were the three foreign banks with the biggest shares of assets in the U.S. last year, according to an April research report by Morgan Stanley. Of those, Deutsche Bank would have had the biggest capital shortfall under the proposed Fed rule, followed by Barclays, the report said. Deutsche Bank has since raised €3 billion ($4 billion), and Barclays is raising £6 billion ($10 billion). Deutsche Bank Chief Financial Officer Stefan Krause told analysts in July that rather than raise more capital to comply—say, by selling shares to the public—the German bank would book some operations in other countries.

The Fed’s proposed regulation for foreign banks is on hold while it completes its plan for strengthening domestic banks. The domestic rule-making has been in the works since 2011 and is unlikely to be issued before the end of this year, estimates Luigi De Ghenghi, a lawyer at Davis Polk in New York. Michael Krimminger, a partner at law firm Cleary Gottlieb Steen & Hamilton, who until 2012 was general counsel for the Federal Deposit Insurance Corp., does not expect the Fed to alter its proposal on foreign banks. “There’s been nothing in the public statements, or any private statements that I’ve received, that they’re planning to change the approach,” he says.

Tarullo, who won’t comment on the Fed’s proposal while the bank is crafting its rule, says he learned something from the Lehman Brothers bankruptcy five years ago and its aftershocks. “By the fall of 2008, strains on the financial system were so great that if it hadn’t been Lehman it would almost surely have been something else,” he says. The lesson: Fix the system now, or another crisis is assured.


    The bottom line: The Fed wants to make sure U.S. units of foreign banks that run into trouble don’t have to write home for money.

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