WASHINGTON — Federal Reserve Board Gov. Jeremy Stein on Monday underscored the need to reform the way the U.S. central bank regulates foreign banking firms that rely heavily on short-term funding.

Stein, along with colleagues, has undertaken research on how shocks in the financial system affect the ability of foreign banks to raise dollar funding and what impact that might have on their lending.

In a speech delivered in Germany, Stein laid out an example to illustrate the predicament that is causing worry among U.S. regulators should there be a liquidity run. European banks, for example, lend in euros to European firms and in dollars to U.S. firms. Typically a significant portion of a foreign bank's dollar abilities are raised via U.S. branches, which are usually precluded from raising deposits insured by the Federal Deposit Insurance Corp.

Because a bank's dollar liabilities are not insured, any adverse shock to the bank's "perceived creditworthiness will result in a spike in its dollar funding costs," said Stein. Meanwhile, the cost to the bank of funding in euros is unchanged, if most of its euro deposits are insured.

"We might expect such a shock to induce the bank to shift its funding away from the U.S. wholesale market and toward the European deposit market," said Stein. "But what are the consequences of this adjustment, both for the geographic distribution of its lending and for the functioning of foreign exchange swap markets?"

The issue has drawn significant attention by U.S. regulators especially as dollar liabilities have grown rapidly in the past two decades. Dollar liabilities by foreign banks are roughly $8 trillion -- about the same as those of U.S. banks.

Based on the analysis conducted so far, Stein says such findings have two kinds of policy implications for central bankers. The first, a response by the Fed to dollar funding pressures and secondly, the necessity for new measures to regulate foreign banking firms that heavily rely on short-term wholesale funding.

"This analysis underscores that the Federal Reserve's temporary dollar liquidity swap lines with the European Central Bank and other central banks are an effective response to stresses in dollar funding market," said Stein. Last week, the Fed agreed to extend its swap lines with the ECB through Feb. 1, 2015.

"These lines have helped avert fire sales of dollar assets and maintain the flow of credit to U.S. households and firms," said Stein.

Separately, the Fed released a proposal last week to overhaul the way it regulates foreign banks operating in the U.S. in order to help address potential disruptions in wholesale dollar funding markets .

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 proposed rules require foreign banking organizations to hold sufficient high-quality liquid assets to meet expected near term net outflows in a stress scenario," said Stein. "These rules should reduce the pressure on foreign banks that rely heavily on short-term dollar funding to either sell illiquid dollar assets or cut back on dollar lending in times of financial stress. By helping to alleviate disruptions in dollar funding markets the rules should also reduce the reliance on swap lines in a future stress episode."

The proposal, which is now open for a 90-day comment period, will impose the same set of requirements on foreign banks that U.S. bank holding companies face.

"The rules will not disadvantage foreign banks relative to domestic U.S. banking firms, but rather the rules seek to maintain a level playing field," said Stein.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.