The Fed, Foreign Banks and the Dollar

Last week, the Federal Reserve announced new standards for foreign banks operating in the US.  The new standards were opposed by many foreign banks and the EU, and the Fed did make two concessions.

First, it initially wanted to make all foreign banks with more than $10 bln of assets in the US subject to the new rules.  It has raised it to $50 bln, which means that 15-20 foreign banks may be impacted.  Second, it has made the effective date July 2016, a year later than initially envisioned. 

In essence, the Federal Reserves news rules are meant to avoid a repeat of the crisis, when it provided almost $540 bln of emergency loans to units of European banks operating in the US.  Previously, the US-based units would lean on their parents  for help, but in addition to this did not prove completely tenable and provided an unfair competitive advantage.  

The Federal Reserve is requiring that foreign banks with a large presence in the US establish a holding company for their operations and hold a minimal level of liquid capital as a financial buffer.  A 4% capital ratio is mandated, but it will not come into effect until 2018.  Note that some large US banks may have to maintain a ratio of 5%.  

Recall that a large German investment bank reportedly had a negative capital ratio and that it and another large foreign bank operating in the US previously had holding companies, but got rid of them, at least in part, to avoid stricter regulatory requirements.  This put them and foreign banks in a competitive advantage over US banks as well as put them ostensibly at greater risk.  

The Fed is also requiring all foreign banks with $10 bln or more in assets to be subject to regular stress tests.  There are around 100 foreign banks that are beyond this threshold. 

While the Federal Reserve's move is understandable, it is also problematic.  It was announced on the eve of the G20 meeting and it has the air of unilateralism about it.    It is both cause and effect of financial fragmentation as countries are seeking to protect their domestic financial system.  That said, the UK reportedly is in the process of adopting a similar set of rules that will require a similar ring-fencing of local operations by foreign banks. 

The Federal Reserve's move was also problematic as it was announced the same week in which the US and European negotiators met to assess the progress (of lack thereof) in the Trans-Atlantic Trade and Investment Partnership talks that were to cover financial regulation, as well.  The EU has threatened to retaliate, but it is not clear that the new rules discriminate against foreign banks.,    Europe seems more frustrated with the way in which this "significant regulator reform was introduced",

The media has played up Deutsche Bank's decision to reduce the assets in its US unit by a quarter to $300 bln.  Yet there is less than meets the eye.  For example, the reduction in its US repo operation is largely a recognition that some of its repo lines were being utilized by clients.   It also reportedly is reshuffling some its operations, such as its Mexican arm and its Frankfurt and Tokyo-based repo business (that are currently organized as part of its US business) to be organized elsewhere.  Clearly this is not a withdrawal from the US, where is has another $200 bln in its US branch that does not fall under the new regulatory threshold. 

The potential dollar impact seem minimal.  The large foreign banks are unlikely to sell US assets in response.  Some may have to replace funding from their parent to local funding.  Some observers have suggested that foreign banks may issue debt abroad and transfer the proceeds to their US entities, but there is more than one way to go about meeting the new capital requirements.  Deutsche Bank, for example, is also considering converting some of the debt its US entity owes the parent to a hybrid debt that could convert to equity capital under specific conditions.  

Nevertheless,  if anything, the Fed's move will increase the price of capital.  Yet this may not be totally undesirable.  Sometimes, economists may suggest that a price of a particular commodity, such as oil, lumber, and alcohol does not do a good job of incorporating externalities.    The same may be true of capital.