The Fed’s new rules for foreign banks and its outcomes

On Tuesday February 18 the Federal Reserve Board unanimously approved its new regulatory structure for foreign banks with significant operations in the United States. This article summarizes the rules and the immediate feedback from the industry.

Here are the facts: despite intense lobbying from the European banking community, the Fed’s final regulations differ only slightly from those originally proposed in December 2012. Under these new regulations, Banks with more than $50 billion of US assets will be required to establish a separate US holding company. They will be required to hold minimum capital as well as maintain a 30 day liquidity buffer and will be subject to regular stress tests. The Fed estimates that this rule will affect between 15 and 20 institutions. The Fed did back away slightly from its original proposal that all foreign banks with US assets over $10 billion would be required to establish a separate holding company, although under the final rules these smaller institutions will still be subject to regular stress tests. This concession probably applies to between 5 and 10 foreign institutions. Foreign banks will have until July of 2016 to comply with the proscribed legal structure and will have until 2018 to comply with the required leverage ratios. The final rule can be found here.

Here’s the pushback: foreign regulators have consistently objected to what they perceive as the Fed’s heavy handed approach to bank regulation. The Global Financial Markets Association, in a comment letter to the Fed, argued that these rules would “exacerbate, rather than mitigate these financial stability risks and harm the global economy.” They went on to argue that these rules “could cause some firms to exit the US market.”

Daniel Tarullo, the Fed governor who oversees regulation emphasized that the Fed’s intention was to strengthen banks to ensure that capital continues to flow during times of stress. He was quoted as saying “I would say that the most important contribution we can make to the global financial system is to ensure the stability of the U.S. financial system.” (Here’s the link.) He also noted in recent hearing by the Senate Banking committee that foreign banks were heavy users of the Fed’s emergency liquidity measures in 2008 and 2009. A Bloomberg article on the subject noted a peak of $538 billion of borrowings by foreign banks.

Under these regulations there are a limited number of options that institutions can employ to avoid this new structure. Undoubtedly one or two institutions at the margin may shrink their US asset base to a level which could allow them to avoid establishing a US holding company. This could be accomplished either by shedding marginal business or by moving some assets off shore. Some banks could elect to operate as a US branch but this would preclude them from participating in most capital market activities. But for global banks that need to maintain a presence in the US capital markets, these new regulations prevent a significant challenge.

Looking over the present US financial landscape, we note that 15 of the current 22 primary dealers are foreign institutions. (We also note that despite protestations to the contrary the Fed added TD Bank to this list on the same day as these regulations were announced.)  Compliance will come at a cost. After several years of raising capital and forgoing dividends it is understandable that European banks will find it onerous to deploy this scarce resource to capitalize a separate US subsidiary. In addition, compliance to the required 4% leverage ratio will force banks to scrutinize their balance sheets and shed marginal assets. This will hit those banks with significant match books the hardest as repo remains a balance sheet intensive low margin business. Articles on the subject in The New York Times, Bloomberg and the Wall street Journal all point to the European banks with large broker dealer operations in the US as the institutions that will suffer the greatest impact.  These include Deutsche Bank (see our read on Deutsche Bank’s reductions here) and Barclays as well as Credit Suisse and UBS.

All of this will serve as another constraint of US repo trading and as another driver to find further efficiencies out of the market’s current business mix. An open question remains whether new players will come in to fill the void or if some portion of the US repo market will be forced to move away from the primary dealer network. In addition; the threat particularly out of Europe is that this new regulatory structure in the US will lead to Europe following a similar path in it market. We will be watching closely to see if the European regulators move beyond rhetoric and on to actual regulation.