The Fed should rethink a banking ring fence

The Fed's proposals to increase regulation of the foreign banks in the US are understandable, but potentially threaten global capital flows and attempts to create worldwide banking rules.

Last December the Federal Reserve Board announced proposals to strengthen its oversight of the US operations of foreign banks. There are those within the industry and, indeed, among the global banking regulatory agencies who see those proposals as threats to the globalisation of the financial system.

The issued surfaced locally today because a submission from the Australia Bankers Association expressing its concerns was posted on the Fed’s website last week but it has been rumbling around the industry since the Fed first showed its hand.

Even the chairman of the Financial Stability Board (and the next governor of the Bank of England) Mark Carney, was moved to write, in a letter to G20 ministers and central bank governors this month, that it was "especially important" that as regulators sought to reduce systemic risks from inter-connectedness "we strive to maintain an integrated global financial system".

"A resilient and global system will provide credit most efficiently and support strong, sustainable and balanced growth. We need to continue to re-build confidence in the long-term robustness of the global financial system and resist pressures to ring-fence national markets," he said.

Carney, about to end his term as governor of the Bank of Canada to take up the UK post in June, didn’t specifically refer to the Fed’s proposals but his comments relate very directly to them and have been echoed in many of the submissions the Fed has received.

The European Commission has warned that, if implemented, the proposals could harm an international economic recovery and could spark retaliation that could end up fragmenting global banking markets.

At face value the proposals don’t look as though they have the potential to undermine financial globalisation and, indeed, the UK has already taken similar steps.

What the Fed is contemplating is a reversal of a deregulatory move about two decades ago that allowed subsidiaries of well-capitalised and supervised foreign banks to operate in the US without having to comply with minimum capital or liquidity requirements. Now the Fed plans to force foreign banks with operations in the US to operate via subsidiaries that are separately capitalised and funded and that will have to meet US liquidity rules.

Given that the requirements are broadly in line with the new global capital liquidity regimes that are being imposed progressively over the remainder of this decade it might appear that the opposition to them is something of an over-reaction. The Fed’s desire to protect US taxpayers from the fallout from a global bank’s collapse is understandable.

The problem that critics of the proposals have with them – and the perceived threat to globalisation – is that the capital and liquidity and funding of the US subsidiaries would be ring-fenced and trapped within them and wouldn’t be available to support the rest of the banks’ operations, even if there were excess capital and liquidity within the US entities. That could severely weaken a global bank’s ability to respond to pressures in some other part of their operations.

There is also a concern that the proposals would adversely impact the competitiveness of foreign banks operating in the US relative to US banks, which could lead to retaliatory "protectionist" measures by other countries. The foreign banks wouldn’t be able to meet the US requirements by citing excess capital held by its parent but a US bank could meet them by including excess capital within its offshore operations.

The Fed’s plan is said to have been prompted by concerns about the US operations of Deutsche Bank. Deutsche’s US subsidiary operates with significant negative equity. Many of the foreign banks also raise longer term funding in the US on behalf of their parents, which then provide them with short-term funding. That mis-match in liquidity could pose a threat to the stability of the US system in any new crisis.

If the Fed presses ahead with the proposals it would almost inevitably see a diminished presence (and less competition) from foreign banks in the US and, if other jurisdictions adopted similar policies, a further diminishing of global capital flows that have already shrunk since the 2008 financial crisis. It might also push more cross-border activity out of the banking system and into the shadow banking sector.

Given that 2008 experience (in which the Fed provided liquidity support for a number of foreign banks, including some of the Australians) there are those who might believe a return to national banking boundaries might not be such a bad thing.

Reducing the ability of capital to flow efficiently from those economies which have a surplus to those with a deficiency, and from using the capital and liquidity within over-funded entities to support those within a group that are light on capital or liquidity could, however, create both inefficiencies and unintended consequences for a system, which does operate globally.

While perhaps understandable, the kind of financial protectionism and fragmentation of regulation the Fed is contemplating also clashes with, and could undermine, the continuing global effort to introduce more conservative and globally consistent prudential standards.

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