The Fed Broadens Its Reach

The crash of 2008 spread almost instantly from country to country, highlighting the interconnectedness of the financial world and making it brutally clear that governments need to cooperate more closely on bank regulation. That effort is faltering, though, which is why the Federal Reserve’s proposal to change its approach to regulating the U.S. operations of foreign banks is justified.

The Fed wants to treat these operations as though they were U.S. banks -- by requiring them to be organized as holding companies and making them pass a U.S. test of capital adequacy. Up to now, the U.S. units of foreign banks were seen as adequately capitalized as long as the foreign parent met the capital standard imposed by the foreign regulator.

The Fed is saying that’s no longer good enough. In response, the European Union calls the Fed’s plan a dangerous and radical departure from the current approach. It says the plan will fragment, rather than unify, global regulation, pile up excess capital and add to banks’ costs.

And that’s not all. Michel Barnier, the EU’s financial-services chief, said in a letter to Fed Chairman Ben S. Bernanke that the U.S. rule “could spark a protectionist reaction from other jurisdictions, which could ultimately have a substantial negative impact on the global economic recovery.”

Let’s first note that if Barnier is concerned about Europe’s protectionist response to the Fed’s proposal, as a top EU policy maker he would be in a good position to prevent it. The implication that the Fed is seeking to give U.S. banks an advantage is, moreover, quite wrong. The proposal puts domestic and foreign banks on the same footing in the U.S. market. That’s a change, admittedly, and a step away from the goal of a single global system of financial regulation. But it isn’t protectionist, and under the circumstances is fully warranted.

In a speech in November, Fed Governor Daniel Tarullo underlined the central problem: For the foreseeable future, he said, “our regulatory system must recognize that while internationally active banks live globally, they may well die locally.” During the financial crisis, the Fed provided more than $500 billion of emergency loans to the U.S. units of European banks. Since then, the concentration and complexity of those firms’ assets, and the risk they pose to the financial system, haven’t diminished. And, as Tarullo added pointedly, “The likelihood that some home-country governments of significant international firms will backstop their banks’ foreign operations in a crisis appears to have diminished.”

All of this justifies stronger oversight by U.S. regulators of foreign banks’ U.S. operations, some separation of their activities and application of the more demanding U.S. capital adequacy test. The U.K. has already adopted similar measures.

To be sure, it’s a pragmatic second-best solution, rather than the ideal. Uniform global regulation is the right answer in principle, so long as it’s sufficiently strict. But as Tarullo says, it’s unlikely anytime soon.

The change would also be unnecessary if EU bank regulation was all it should be. It isn’t. European banks are not as well capitalized as American banks, and EU regulators have been dragging their feet.

The Fed’s proposal will indeed require European banks to raise more capital for their U.S. operations -- and that’s the point. The last thing anybody needs to worry about right now is that banks anywhere, let alone European banks, have too much capital.

A shortage of capital poses serious risks to the U.S. financial system and taxpayers. When EU regulators have greatly improved their performance on bank safety, they will be in a better position to argue that they can be trusted to take care of their banks’ foreign operations, and to call the Fed’s regulatory fragmentation a bad idea. Until then, the Fed’s proposal makes excellent sense.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at