Are The Fed’s Guidelines For Foreign Banks Discriminatory?

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It is no secret that the Federal Reserve has been pondering ways to tighten regulations on foreign banks with a presence in the U.S., with the central bank first hinting at it in late 2012 (see Fed Likely To Tighten Regulatory Noose Around Foreign Lenders). So when the Fed actually released its guidelines about this contentious matter earlier this month, foreign lenders weren’t really caught by surprise. [1] However, these new rules have drawn a considerable amount of criticism since then from foreign banks as well as financial regulators abroad, who allege that they tip the balance in the U.S. banking industry against foreign financial institutions.

The new guidelines mostly affect 17 foreign banks with more than $50 billion in non-branch assets in the U.S., as they will need to set up an intermediate U.S. bank holding company that consolidates their entire business in the country, and this holding company will be subject to capital requirements and stress tests similar to what U.S. bank holding companies currently face. [2] Deutsche Bank (NYSE:DB), Barclays (NYSE:BCS), UBS (NYSE:UBS) and Credit Suisse (NYSE:CS) are expected to be hit hardest by the new rules, which will require them to raise billions in fresh capital. Other foreign banks with more than $10 billion in assets will also come under additional regulatory scrutiny.

So are the rules actually onerous and discriminatory? While the rules will undoubtedly pinch the foreign lenders, it also may be an essential step toward a more resilient banking industry .

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Fed Has A Reason To Target Largest Foreign Lenders

The aforementioned international banks play a very substantial role in the U.S. markets, with quite a few of them figuring in the list of banks responsible for some of the mortgage-related practices that fueled the economic downturn of 2008. In the aftermath of the downturn, the Fed gave out the same amount of emergency loans to foreign banks as it did to U.S. banks. Today, foreign banks hand out roughly a quarter of all commercial and industrial loans in the U.S. ((U.S. Said to Weigh Tightening Rules for Foreign Lenders, Bloomberg, Nov 27 2012))

The Fed, therefore, could not overlook the large foreign lenders if it were to deliver on its task of strengthening the country’s banking industry. And the fact that some foreign banks tried to side-step capital requirements as laid out by the Dodd-Frank Act by removing their ‘bank holding company’ status in the country made it necessary for the regulator to come up with stricter guidelines for all of them (see Deutsche Bank No Longer a U.S. Bank; What Does This Mean?).

So What Does It Mean For The Foreign Banks?

Forcing these large foreign banks to create umbrella bank holding companies in the U.S. will bring the newly formed holding companies under the jurisdiction of the Dodd-Frank Act. Consequently, the holding companies will need to meet the capital requirements specified by the act – which would mean that the banks will have to pump in billions of dollars into their U.S. subsidiaries over the next year to be compliant with these requirements. Also, the banks will be subject to annual stress tests in the same way that U.S. banks are.

Deutsche Bank was the first among the foreign lenders to react to these new rules, with the German banking group announcing its decision to slash its balance sheet in the U.S. by 25% – from $400 billion to $300 billion – in order to meet the requirements. [3] The bank will achieve a bulk of this reduction by reassigning several business units, which operate outside the U.S. but are a part of its U.S. subsidiary, to other non-U.S. based subsidiaries. Other banks that will be affected by this move by the Fed are also expected to take similar actions.

While funding costs linked to the additional capital will drag down the net interest margins for the banks’ U.S. operations, it will also restrict the ability of the parent companies to move funds across regions. Also, the banks will incur higher operating costs to ensure regulatory compliance in the future – adding pressure to operating margins. The impact of a reduction in interest margins on Deutsche Bank’s total value can be understood by making changes to the chart above.

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Notes:
  1. Federal Reserve Board approves final rule strengthening supervision and regulation of large U.S. bank holding companies and foreign banking organizations, Federal Reserve Press Release, Feb 16 2014 []
  2. Fed Adopts Foreign-Bank Rule as World Finance Fragments, Bloomberg, Feb 18 2014 []
  3. Deutsche Bank to cut US unit’s assets by quarter to meet Fed rules, Financial Times, Feb 23 2014 []