Fed's demands on foreign banks' capital signals loss of trust

The days of the US allowing zero capital activity are over, writes Floyd Norris.

There was a time, not long ago, when bank regulators around the globe trusted one another. Those days are gone.

Despite a lot of talk about the need for international co-operation in regulation, it appears US regulators intend to assure that foreign banks operating in the US have adequate capitalisation.

Until the financial crisis, the Federal Reserve was happy to allow US subsidiaries of foreign banks to have no capital at all, and some did not. At the end of 2007, Deutsche Bank's US operations reported having a negative $US8.8 billion in capital. How could any regulator allow that?

The idea was that the presumably well-capitalised parent would stand behind the US operation if it ran into trouble. And the US could rely on home countries to regulate their banks and, if something went badly wrong anyway, provide bailouts. But as the crisis approached, funny things were happening.

Until 2000, US operations of foreign banks tended to receive financing from home. But as the credit party grew after 2003, those banks increasingly borrowed in America's short-term markets and sent the money home to the parent.

When the credit crisis appeared, that financing - a significant part of which had come from selling short-term securities to US money market funds - dried up.

In December, the Fed proposed new rules that would require US subsidiaries of each foreign bank be put together in a holding company that would have to maintain capital, and liquidity, in the US. In some cases the requirements would be greater than home countries require of the parent institutions.

In a letter to the Fed, Michel Barnier, the European commissioner in charge of internal markets, complained that the proposal was "a radical departure" from internationally accepted policies. He warned that if the Fed did not back down and accept that Europe will do a perfectly good job of regulating its own banks, the new rules "could spark a protectionist reaction" from other countries and bring on "a fragmentation of global banking markets and regulatory frameworks".

It is no coincidence that it is the countries with the largest financial systems that seem to be most determined to protect themselves. The examples of badly run oversize financial systems in Iceland, Ireland and now Cyprus have made the risks crystal clear. European regulators who trusted Iceland to regulate its banks wound up paying off depositors even though there is little hope Iceland will ever reimburse those payments.