Commentary

No Banking Sector Is an Island

A number of recent proposals highlight two worrying trends in financial services regulation: the increased tendency for countries to build walls around their domestic operations and the tendency of regulators in the largest markets to exert control outside their borders. These trends are of particular concern to the less economically powerful countries and regions that rely heavily on the global financial services industry to generate growth.

Proponents of the various proposals argue that the measures are aimed at protecting domestic taxpayers rather than limiting competition or cross-border capital flows. But the actions may yet have some serious unintended consequences.

In the United States, the Federal Reserve used the broad oversight powers granted to it under the Dodd-Frank Wall Street Reform and Consumer Protection Act to release rules governing the US operations of foreign banking organisations (FBOs) in December 2012. The rules require that the US-based subsidiaries of all FBOs with in excess of $10 billion in US based assets must reorganise their US operations under an intermediate banking holding company, mimicking the structure that applies to US-based organisations.

Moreover, the intermediate holding company has to be separately and individually capitalised in accordance with US Basel III rules. This requirement applies even if the FBO is already Basel III compliant in its home jurisdiction. In addition, each significant branch and agency of the FBO, while not forming part of the new “holding company” structure would need to individually and separately from the parent meet all US capital and liquidity requirements.

Are we headed towards a “balkanisation” of the international financial services industry?”

The Fed has argued that this proposal makes it easier to implement bankruptcy proceedings in the event of a failure of the FBO parent or the US subsidiary and to limit the so-called “systemic” consequences within the US, including to make a failure of a US subsidiary less likely. But the proposal creates some, not insignificant, problems. Firstly, the proposal will be costly and difficult for the FBO to implement from a procedural perspective and may require duplication and contradictory application of capital and liquidity requirements. This is particularly true in the case of globally systemically important financial firms or “G-SIFIs” where the home country regulator generally applies the capital and liquidity requirements on a group consolidated basis, rather that at the subsidiary level.

If only the United States implements this approach, the effect would be to make it more expensive for foreign banks to do business in the United States. The real danger, however, is that other countries follow suit, leading to a classic race to the bottom. According to eminent bankruptcy lawyer Rodgin Cohen, speaking on a recent panel at the US Chamber of Commerce, this could spark a set of circumstances that places the financial services industry on the same path as the Smoot-Hawley inspired tariff wars of the 1930s.

Perhaps even more importantly from a global perspective, in the event of a crisis funds could potentially end up trapped in subsidiary operations and will not end up where they need to be from an organisation perspective. And if the US subsidiary of a foreign bank gets into trouble, some commentators worry that the parent will be far less likely to step in to provide capital and or/other assistance. Further, if regulators in other countries follow the Fed’s lead, it could paralyse cross-border capital flows in the event of another crisis (a possibility made more rather than less likely by some of the recent regulatory developments). It is also less likely that non-domestic banks in stronger positions will want to step to assist weaker domestic banks during a crisis.

This phenomenon made the 2008 financial crisis less severe than it could have been — for example, Morgan Stanley survived the crisis largely thanks to an injection from Japan’s Mitsubishi.

And the United States is not the only culprit. The United Kingdom’s recent “ring-fencing” proposals aimed at domestic retail bank operations are also concerning. The details of the rules have yet to be ironed out, but there is a concern that the rules will serve to limit competition in the UK’s domestic retail market, hurting UK consumers of financial products, while not affording any real protection to UK taxpayers and depositors.

But it is not just local authorities’ treatment of the local operations of foreign banks that is problematic. For offshore tax and financial services havens, an even bigger concern going forward is the extraterritorial reach of regulators exercising their post-financial crisis muscle.

Aside from the United States’ FATCA implementation, an approach now being adopted by France, the United Kingdom and other jurisdictions, another area of concern is the cross-border application of the United States’ derivative reforms. Under Dodd-Frank, the Commodities Futures Trading Commission has jurisdiction over OTC derivatives and traditional swaps only. Other types of security-based swaps are regulated by the Securities and Exchange Commission , an agency that has been much more deferential to, and respectful of, home country authority.

In terms of the guidance that the CFTC released in July 2012, foreign registered swap dealers and “major swap participants” would be permitted to substitute home-country rules for the CFTC’s requirements only if the CFTC is given direct access to swap data. Foreign swap dealers and participants may also choose to comply with home-country law under the “substituted compliance” regime for those swaps only guaranteed by US persons. But even in this case, the home country rules can only be applied in place of the CTFC rules if they are “equally stringent”, a concept that is a very vague and subjective and difficult to implement as countries take very different approaches to swap regulation.

The CFTC example is a fairly technical one, but coupled with FATCA implementation and the general financial regulatory frameworks adopted in key jurisdictions, it illustrates a broader trend — one where over-zealous national regulators, empowered with ill-defined and overbroad statutory authority start legislating for other jurisdictions. This then further encourages the inward-looking nature of banking reforms as a local authorities attempt to protect their jurisdictional oversight from outside interference.

To date, there have been no econometric or other studies or models predicting what the cumulative cost or effects of heading down this path would be. One is urgently needed. Until then, some of the world’s financial powerhouses could do to take a lesson from their smaller brethren and remember that policies allowing for ease of cross border capital flows and simpler, foreign bank-friendly regulatory structures have heralded an era of unprecedented growth and development. Turning back now would be a mistake.

Louise C. Bennetts is the associate director of financial regulation studies.