WASHINGTON — After spending nearly a year deliberating on an approach, the Federal Reserve Board on Friday released a proposal that would overhaul the way regulators will supervise foreign banks that operate in the United States, a significant shift from its longstanding case-by-case method.
The board unanimously voted at an open board meeting to release the plan, which was initially foreshadowed in a speech made by Fed. Gov. Daniel Tarullo late last month.
The proposal, which is now open for a 90-day comment period, represents a shift in the way the central bank plans to supervise foreign bank operations by imposing the same set of requirements that U.S. bank holding companies face.
"The draft regulation being presented to us this afternoon would make a significant change in the board's approach to regulating the activities of foreign banks in the United States," Tarullo said at the Fed's meeting. "Applicable regulations have changed relatively little in the last decade, despite a significant and rapid transformation in the activities of foreign banks, many of which moved beyond their traditional lending activities to engage in substantial, and often complex, capital market activities."
The shift in supervisory approach has long been expected since the financial crisis revealed to regulators flaws with the current process. Many had been expecting such changes given the failure of Lehman Brothers, which had a substantial broker-dealer subsidiary in the U.K., and severe distress at certain non-U.S. banks with operations in the U.S.
"The financial crisis exposed flaws in the precrisis structure for supervising and regulating both large U.S. banking organizations and the U.S. operations of large foreign banking organizations," said Fed Chairman Ben Bernanke at the meeting. "Just as the domestic proposal addresses financial stability risks posed by large U.S. financial institutions, this proposal includes targeted changes to our regulatory approach aimed at addressing the risks posed by the U.S. operations of large foreign banks."
Congress required regulators under the Dodd-Frank Act to reform the way they supervise foreign bank operations with $50 billion or more of globally consolidated assets and a presence in the U.S. Adding to that, a provision in the reform law by Sen. Susan Collins, R-Maine, also calls for large foreign banks to restructure their U.S. operations.
In its approach, the Fed avoided choosing either of two extremes — a full subsidiarization where all branches and entities are placed below the holding company and maintaining the status quo — instead seeking a moderate way to allow foreign banks' branches and agencies to stand alone and provide firms enough time to comply with the new rule.
"The proposal takes a middle road among the various possible alternative approaches," Tarullo said.
He said it would have been "neither prudent nor practical" if regulators opted from refraining to make changes to how they regulated foreign banks. On the other hand, had regulators considered taking a "fully territorial" approach, that could have potentially led to reduced credit availability in the U.S., he said.
"Given the size, scope, and importance of the largest foreign banking operations in the United States, it would be imprudent not to have a mix of strong, uniform regulatory standards and more tailored supervisory oversight, as we do for domestic banks of similar importance for financial stability," Tarullo said.
The scope of the Fed's plan will affect a total of 107 foreign banks operating in the U.S. However, the Fed opted to take a tailored approach with its plan, divvying up the banks into two buckets with some having to face the toughest set of requirements.
More than two dozen foreign banks with more than $50 billion of globally consolidated assets will be required to place their operations under a first-tier U.S. intermediary holding company. The firm's U.S. branches and agencies will not have to be part of the holding company, but would still be subject to separate measures, including liquidity requirements.
The other 84 firms will face a "reduced set of requirements" because they don't meet the size threshold. Institutions will be given until July 1, 2015, to implement the new set of rules.
One of the concerns raised by the proposal is that foreign countries may potentially make it harder for U.S. banks to operate in their countries.
Wayne Abernathy, executive vice president of financial institutions policy and regulatory affairs for the American Bankers Association, said the proposal could potentially harm both banks operating in the U.S. as well as U.S. banks operating abroad.
Jaret Seiberg, a policy analyst with Guggenheim Partners, agreed.
"For the domestic mega banks, this is a mixed development," he wrote in a note to clients. "It should give them a competitive advantage over their foreign bank rivals for lending and investment banking activities. Yet it also runs the risk of triggering a trade war that could result in domestic banks facing costly requirements in foreign countries."
Federal Reserve officials said it's difficult to predict whether or not foreign governments would take such steps against U.S. institutions.
Banks that are likely to be affected by the proposed regulation include Barclays, Deutsche Bank, and HSBC.
"We are reviewing the proposed rules and, based on earlier Federal Reserve Board comments, we are confident that we have options that will allow us to implement the new regulations in the prescribed timeframe," said Michael O'Looney, a spokesman for Barclays, in a statement. Representatives from Deutsche Bank and HSBC could not be immediately reached for comment on the Fed's draft rule.
Sally Miller, the CEO of the Institute of International Bankers, warned that the proposal could force foreign banks out of U.S. markets.
"Our initial take is that while the proposal is tailored to some extent, the Fed's approach is nevertheless overly broad and could prompt foreign banks to pull back from the U.S. market, hurting our economy and financial markets," she said. "We believe the more rational approach — consistent with the intent of Congress — is to concentrate on the very small number of foreign banks whose U.S. operations could actually be considered to present risks to U.S. financial stability. This can and should be done on a case-by-case basis."
Under the Fed's proposal, the largest foreign firms will have to meet similar capital and liquidity requirements that U.S. bank holding companies with more than $50 billion of assets face under Dodd-Frank. Foreign banks will also be expected to meet liquidity risk management standards, single-counterparty credit limits, and stress testing requirements.
For example, under the plan, the U.S. intermediary holding company of a foreign financial institution would have to maintain a full 30-day liquidity buffer in the U.S. The company's branches and agencies would only have to maintain the first two weeks of its 30-day liquidity buffer in the U.S., while the remainder of its liquid assets could be kept with its parent. Additionally, a foreign bank organization that met the $50 billion threshold of would also face an internal liquidity stress test each year.
Separately, the plan would limit an intermediary holding company's credit exposure by establishing a threshold of 25% of regulatory capital for exposure to a single counterparty and an even tougher limit for credit exposure of a major U.S. intermediary holding company with $500 billion of assets or more. The Fed did not set a specific limit in its plan.
Each intermediary holding company will also have to face the same stress testing exercises as its U.S. counterparts each year. Foreign banks with $10 billion or more of globally consolidated assets will be subject to a similar stress testing exercise by its home supervisor.
The new requirements will also apply to any nonbank foreign financial firm that is designated by the Financial Stability Oversight Council as systemically risky. Federal Reserve officials did not specify how they plan to regulate such firms under the new requirements, but suggested they would do so on a case-by-case basis.