How US prudential standards could fragment global market

Author: Ashley Lee | Published: 29 Oct 2013
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  • Proposed regulations regarding the implementation of sections 165 and 166 of the Dodd-Frank Act require foreign banking organisations with a significant US presence to create a US intermediate holding company over their US subsidiaries;
  • Those intermediate holding companies will be subject to US capital requirements, requiring foreign banks to silo capital within the US;
  • International regulators and banks have warned that these measures are unfair to foreign banking organisations and may spark copycat regulations from other jurisdictions.

The implementation of proposed US prudential standards for foreign financial institutions represents another extraterritorial measure under the Dodd-Frank Act. The rules may prompt a domino effect that would be especially devastating to emerging market banks.

Sections 165 and 166 of Dodd-Frank propose that foreign banks with a significant US presence create a US intermediate holding company over their US subsidiaries and hold capital within the US.

In a December 2012 press release, US Federal Reserve Chairman Ben Bernanke justified the proposed rulemaking, saying that they address the risks that large, interconnected financial institutions pose to US financial stability. But the proposal of these regulations revealed that the Fed may not have confidence in its peers.

"It’s unfortunate that there appears to be a lack of trust between regulators such that their counterparts fear how they would be affected in a bank resolution scenario," said Alan Avery, a New York-based partner at Latham & Watkins.

The proposed regulations

The regulations proposed rely on a bank’s total consolidated assets to determine implementation standards.

Any publicly-traded foreign banking organisation with total consolidated assets of $10 billion or more, and any foreign banking organisation – either privately or publicly traded – with total consolidated assets of $50 billion globally must establish a US risk committee.

Those that have $50 billion or more in total consolidated assets globally but less than $50 billion in the US must meet home country stress test requirements that are broadly consistent with US requirements, as well as home country capital standards broadly consistent with Basel standards.

If their non-branch US assets exceed $10 billion, they must form a US intermediate holding company, which will be subject to US bank holding company capital requirements.

Those with over $50 billion in global and US assets – even those without a US bank or insured depository institution – must also establish an US intermediate holding company. That company, along with the bank’s agency and branch networks, will be subject to monthly stress tests and in-country liquidity requirements.

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Global reaction

Avery noted that the banks that will be most affected are those with large non-bank operations, such as broker-dealer operations, in the US. These are mostly European banks due to the nature of their businesses.

Most of the comments from these organisations focused on the mandatory establishment of an intermediate holding company subject to US bank holding company requirements and enhanced prudential standards.

In its comment, Credit Suisse criticised the so-called one-size-fits-all requirement of the intermediate holding company, as it entirely disregards home country standards. It added that the requirement appeared to contravene the Dodd-Frank directive to take into account the comparability of a foreign bank organisation’s home country standards when imposing enhanced prudential standards on its US operations.

Banks with a smaller presence in the US also expressed concerns. Many international banks maintain small operations in the US for cash management and foreign exchange, and may fall under these regulations’ requirements even without a significant impact on the US financial system.

Some noted the proposal’s implications on efforts to establish a global bank resolution regime. UBS warned in its comment that the proposed rules signal a lack of confidence on the part of the board in the ability of global regulators to continue working together cooperatively to supervise and potentially resolve internationally active banks.

"Wholly local resolution is a sub-optimal solution which would likely lead to higher overall losses," it said.

Regulators around the world agreed. Michel Barnier of the European Commission said in his comment the proposed rules could spark a protectionist reaction from other jurisdictions. This could ultimately have a substantial negative impact on the global economy, and retaliation efforts could end up in fragmentation of global banking markets and regulatory frameworks, raising costs for banks globally.

Further, he added, it would affect cooperation among regulators and, if replicated by other regulators, would preclude the possibility to resolve a global systemically important institution (G-Sifi) in a coordinated manner among different national authorities.

Shin Je-yoon, chairman of Korea’s Financial Services Commission also warned that competition among countries may lower regulatory effectiveness since standards are likely to be inconsistent and overlapping.

What to expect from the US

Banks that meet the $50 billion threshold by July 1 2014 must comply with the new standards – although they haven’t yet been finalised – by July 1 2015.

Some banks are managing their size to avoid putting capital into US intermediate holding companies, said Avery. But those that are large enough and are unable to restructure in the near future are planning how to meet the capital requirements in the proposed rules.

The finalised rules are likely to look similar to those proposed last December. However foreign banks – even those with small operations – are unlikely to leave the US because of these rules as their domestic clients with US business need their services.

But in the best-case scenario, there will be greater cooperation between regulators to decrease the burden on foreign banks.

Avery said that market participants are hopeful that there is more proof of bilateral and multi-lateral agreements among regulators to restore trust and require less capital to be ring-fenced locally.

"For example, the Federal Deposit Insurance Corporation and the People’s Bank of China recently announced a Memorandum of Understanding on bank resolution," he added. "That helps regulators build trust and communications across jurisdictions."

Asian implications

Global regulations regarding the local ring-fencing of capital could have a particularly adverse effect on the Asian markets.

Rebecca Terner, executive director of policy and regulatory affairs at the Asia Securities Industry & Financial Markets Association’s (Asifma), warned of the adverse effects of silo-ing local capital.

Looking across the Asia-Pacific region, she observed that banks’ capital adequacy is on the rise, and the non-performing loan situation is improving. Some of the world’s strongest and best-capitalised banks are located in this region.

"A regulatory regime related to ring-fencing local capital of banks isn’t addressing the issues in Asia; it addresses issues in the global markets," she said. "But it may have dire effects if implemented indiscriminately in Asia."

While the US’ rules have not yet been implemented, Asian jurisdictions are considering similar prudential standards for foreign bank subsidiaries.

Speaking with IFLR in May about an Asifma report on Asian bank resolution regimes, Asifma’s chief executive officer Mark Austen warned that local requirements in Asia to capitalise domestic subsidiaries raise the cost of cross-border activity, and ultimately clients bear the cost.

"It also flies in the face of such initiatives such as the G-30’s proposals regarding long-term funding of infrastructure, which requires greater cross-border activity," he said.

On September 30, it was reported that China Banking Regulatory Commission (CBRC) issued draft regulations that propose foreign-funded bank subsidiaries’ minimum paid-up capital be increased from RMB 300 million to RMB 1 billion, in line with its standards for domestic nationwide commercial banks. The Reserve Bank of India is also contemplating a requirement for foreign banks entering India to establish a local subsidiary.

Related links

How to fix global banking

Asifma: Asia’s bank resolution regimes must look globally

Volcker Rule to prompt bank exodus from the US