Fed’s Final Foreign Bank Rule Increases Risk in Global Banking

Despite this negative trend, this week’s release by the Federal Reserve of its final foreign banking organization rule indicates that the world’s leading financial services economy will continue on a protectionist path. We believe, along with many others, that the Federal Reserve’s action will further impede global capital flows, threatening to undermine not only the already‐​weak recovery, but also the ability of the financial sector to address future crises.

The FBO rule began as a proposal in December 2012. Its principal aim was to make large foreign banks operating in the U.S. subject to a uniform corporate structure. Such banks would be required to organize virtually all of their nonbranch operations under an “intermediate” holding company regulated by the Federal Reserve. The IHC itself would need to comply with the United States’ Basel III capital and liquidity rules — a reversal of decades of regulatory practice. The proposal was much criticized, including in a November policy study released by us. Although the final rule applies the IHC requirement to fewer foreign banks and gives those banks more time to comply, the basic intention remains unchanged.

At its core, the rule evinces a clear theme: that policymakers believe the actual corporate structures of large banking groups are a threat to financial stability, and banks must undertake costly restructuring exercises to mitigate this risk.

We disagree. The rule prohibits the largest, most sophisticated foreign banks from allocating capital and liquidity in a manner they deem to be most efficient. This may be an acceptable price to pay if the overall result were enhanced stability. However, trapping capital and liquidity in particular jurisdictions is likely to make large banks less resilient in times of crisis, not more.

We believe that the effects of the financial crisis would have been even worse had liquidity not flowed as freely across borders. The danger of the final rule is that it limits the ability of internationally active foreign banks to deal with capital and liquidity shortages before they become the taxpayers’ problem. That’s because imposing costly and inflexible corporate restructuring is a form of pre‐​crisis ring fencing. In turn, this makes banks’ capital and liquidity structures more fragmented and less capable of speedy adjustments.

Another probable effect of this growing protectionism will be a retreat by globally active banks to their home markets. Ironically, this is likely to lead to more home market concentration and less global diversification, making banks in all countries more susceptible to shocks. And this doesn’t take into account the likely impact of actions by foreign regulators now that the FBO rule is final — European Union Commissioner Michel Barnier warned of retaliatory measures if the Federal Reserve maintained the IHC requirement.

The final rule takes the position that an intermediate holding company structure is superior to other forms of foreign bank organization, even though there is no clear support for this position. Some residual doubts may even be present at the Federal Reserve. In this week’s meeting, even Governor Daniel Tarullo, a strong supporter of the rule, stated that the rule may not strike the right balance indefinitely.

The path of protectionism, as the McKinsey study notes, may well lead to a “balkanized structure that relies more heavily on domestic capital formation … [providing] too little financing for long‐​term investment.” We would add that it could also reduce the stability of the global banking sector. Although the ultimate goal — better protecting domestic taxpayers — is a noble one, we question whether the Fed’s action will achieve it.