Fed should supervise foreign banks like their U.S. counterparts

Foreign banks, like their domestic counterparts, play a critical role in the United States' financial system. They hold more than $5 trillion — or one-fifth — of total banking assets; provide one-third of small-business loans; and finance more than one-third of infrastructure projects. And, as with U.S. firms, the 2008 financial crisis exposed the vulnerabilities of foreign banks' risk management procedures.

Yet, despite their similarities, the largest foreign banks are not subject to the same oversight as their U.S. peers.

Al Drago/Bloomberg

In 2020, then-Federal Reserve Vice Chair for Supervision Randal Quarles removed the four most systemically important foreign banks — Credit Suisse, Barclays, Deutsche Bank and UBS — from the agency's most rigorous supervisory program, the Large Institution Supervision Coordinating Committee (LISCC). Instead, he moved these firms into the less onerous Large and Foreign Banking Organization (LFBO) group as part of his and other Trump appointees' efforts to roll back key post-crisis reforms. Without appropriate supervisory oversight, the Fed has left open greater potential for these firms to engage in riskier activity, putting broader financial stability in jeopardy. 

Last month, President Biden's nominee Michael Barr was sworn in as Quarles's successor. As the Fed's top banking regulator, Barr should quickly restore the Fed's supervisory oversight of these four foreign banks and reimpose standards aimed at creating a safer and more sound U.S. financial system. 

The Fed established the LISCC program to help fulfill its statutory mandate to supervise the most systemically important financial institutions, i.e., firms whose failure would result in significant risks to financial stability. The LISCC program is made up of a multidisciplinary group of Fed board and reserve bank staff conducting ongoing, frequent, horizontal and firm-specific reviews. Through these exercises, supervisors can identify and address potential risks at the individual firm level and across the peer group. Throughout the decade after the financial crisis, resultant reforms have accomplished what they have set out to do: LISCC-portfolio firms are less risky, better capitalized and have robust liquidity.

However, the Trump administration's deregulatory agenda and appointment of laissez-faire banking regulators has chipped away at many of these post-crisis reforms. For much of the program's existence, the largest and most complex domestic and foreign banks were supervised similarly under the LISCC regime. In removing the foreign banks from LISCC, Quarles cited the decrease in their U.S. operations and risk profile over the preceding decade.

Quarles's rationale for moving the foreign banks out of LISCC and into the LFBO portfolio was that doing so would promote greater transparency into the Fed's regulatory and supervisory agenda by aligning LISCC with the framework established in the agency's 2019 "tailoring" rule.

At a high level, the tailoring rule categorized firms based on their size and risk profile, placing each bank into one of four categories. The rule limited Category I to U.S. global systemically important banks — by definition excluding large foreign banks, including those removed from LISCC.

Importantly, the rule has downstream deregulatory implications for the foreign banks. To name a few, the Fed cut liquidity standards for these foreign banks and removed the requirement for such firms to calculate their capital ratios using sophisticated financial models. Altering the tailoring rule requires action by the three banking regulators and a laborious notice-and-comment period. Moving the foreign banks into LISCC can be a relatively quicker alternative to ensure firms are being adequately supervised in light of reduced regulatory standards.

While the LFBO program conducts some horizontal analysis, much of its supervisory activity is performed on a firm-specific basis and occurs less frequently than under the LISCC program. The differences in each program's approach to supervision directly ties to how much time examiners spend supervising.

In 2019, for instance, Fed examiners spent an average of 55,000 supervision hours per LISCC institution and just over half of that on LFBOs. Across areas of focus — such as capital planning, liquidity risk management, governance and controls — LFBO firms are generally subject to less demanding examination and exercises than LISCC firms.

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Even before the tailoring rollbacks, large foreign banks have taken advantage of regulatory and supervisory blind spots. After the financial crisis, foreign banks were required to form intermediate holding companies (IHCs) to house their U.S. operations.

These IHCs are generally subject to enhanced regulatory oversight. However, firms were allowed to conduct activity via branches, or separate legal entities that are lightly regulated compared with IHCs. Over time, the branches of the four LISCC foreign banks have ballooned, growing by 42% from 2016 to 2019, while their IHCs have shrunk. The shifting of assets from IHCs to branches without commensurate oversight poses serious risks to U.S. financial stability. In lieu of closing this regulatory loophole, greater consolidated supervision of these firms can play an important role.

It is also worth noting that much of the momentum behind the tailoring rule and decision to remove the foreign banks from LISCC started well before major global economic, health and geopolitical shocks such as the COVID-19 pandemic and the Russian invasion of Ukraine. Banks generally coped well throughout the pandemic, in large part thanks to post-crisis reforms requiring them to hold greater capital and liquidity.

With respect to the conflict in Ukraine, however, the board's latest Supervision and Regulation report found that investors' confidence in a firm's capital position declined earlier this year for U.S. banks, and even more so for European firms. This is relevant because the four foreign banks removed from LISCC are headquartered in Europe. The interconnectedness of these firms to U.S. financial markets is evident, and the uncertainty surrounding the future of the conflict is just one example of why these firms should be subject to the strictest supervisory standards.

Foreign banks, in many respects, are as important players in the U.S. financial system as their domestic counterparts. They should be regulated and supervised accordingly to ensure that they have the proper risk management practices in place to avoid conditions that could ultimately contribute to a future financial crisis. While reforming the tailoring rule will require action by the three federal bank regulators, Barr may unilaterally place the four largest foreign banks back into the LISCC portfolio. For the stability of the financial system, he should quickly do so.