Fed Governor Daniel Tarullo Speech on Regulation of Foreign Banking Organizations (Very Significant Speech) (with Lofchie Comment)

Federal Reserve Governor Daniel K. Tarullo gave a speech discussing what he termed a "practical and reasonable way forward" in the U.S. regulation of foreign banking organizations. In Governor Tarullo's speech, delivered at the Yale School of Management, he noted that the profile of foreign bank operations in the United States changed significantly in the run-up to the financial crisis (see also attached study), shifting from a "lending branch" model to a "funding branch" model, in which U.S. branches of foreign banks began borrowing large amounts of U.S. dollars "to upstream to their parents." The financial crisis, Governor Tarullo argued, has served to reveal the financial stability risks associated with the foreign banking model as it has evolved in the United States. One of these dangers, Governor Tarullo noted, is that a global bank's capital and liquidity can end up "trapped at the home entity" in the event of a failure.

Governor Tarullo stated that as a result of the changes in the activities of foreign banks and the risks attendant to those changes, regulators will need to adjust the regimes applicable to foreign banks. In particular, Governor Tarullo outlined the following prospective changes:

• A "more uniform structure" for the largest U.S. operations of foreign banks, which would require that they establish a top-tier U.S. intermediate holding company (an "IHC") over all U.S. bank and non-bank subsidiaries. Governor Tarullo argued that this would allow for more consistent supervision across foreign banks, and would also reduce the ability of foreign banks to avoid U.S. consolidated-capital regulations. The U.S. branches of foreign banks would themselves be outside the IHC structure.
• The same capital rules applicable to U.S. BHCs should also apply to U.S. IHCs.
• There should be liquidity standards for large U.S. operations of foreign banks (including, apparently, US branches of foreign banks). For IHCs, the standards would be "broadly consistent with the standards the Federal Reserve has proposed for large domestic BHCs."

Governor Tarullo noted that the Fed expects to issue a notice of proposed rulemaking in line with the basic approach outlined above "in the coming weeks."

Lofchie Comment: Governor Tarullo suggests a significant change in the manner in which the U.S. operations of non-U.S. banks are regulated, including requiring non-U.S. banks having bank and corporate subsidiaries in the United States to be held underneath a mid-tier subsidiary referred to as an IHC. The IHC would be regulated much like a U.S. bank holding company (even if none of the subsidiaries are depository institutions) , and thus would be subject to U.S. regulation, including, significantly, liquidity and capital regulation (including the higher capital requirements imposed under Dodd-Frank's prudential regulation and Collins Amendment provisions). The U.S. branches of non-U.S. banks, while not held inside the IHC structure, would also be subject to additional regulation, in particular, new liquidity requirements. Governor Tarullo provides a number of reasons as to why such a shift in U.S. policy is required including the following: (i) non-U.S. banks have become net borrowers in the United States, rather than net lenders to the United States; (ii) during the financial crisis, non-U.S. banks were directly supported by the Fed (as well as their home country regulators); (iii) in a future financial crisis, Governor Tarullo believes that non-U.S. governments may be less willing or able to support the U.S. branches of their home country banks, thus increasing their potential need for support from the Fed or the potential that their failure disrupts the U.S. economy; and (iv) non-U.S. banking organizations play a major role in the U.S. banking and securities markets (five of the top ten securities firms in the United States are subsidiaries of non-U.S. organizations). Governor Tarullo's proposal would require that foreign banking organizations that have no U.S. banking subsidiary but have other activities in the U.S., such as securities or lending activities, create an IHC that would then be subject to Fed regulation and oversight, and, in particular, capital and liquidity standards. Foreign banking organizations that do have U.S. banking subsidiaries would have to hold these subsidiaries in a US bank holding company, and could no longer hold the US banking subsidiary directly from a parent holding company located abroad.The legislative and regulatory changes suggested by Governor Tarullo would substantially expand the authority of the Federal Reserve to regulate capital and liquidity of the U.S. operations of foreign banking organizations, and the creation of a new form of Fed regulated vehicle. In that regard, he is suggesting a very substantial re-thinking of the manner in which the U.S. operations of global financial institutions are regulated.

Click here to view speech in full (links externally to Federal Reserve website). See also related Federal Reserve Study: "Foreign Banks in the U.S.: A primer"