Recently, tariffs and the potential for trade wars and reductions in global economic growth have been much in the news. News reports convey constant, growing alarm, and politicians and policymakers are highly focused on the issue. Meanwhile, though, global bank regulators are quietly instituting a tariff regime of their own, which should raise similar concerns.
All seem to agree that global trade makes all countries better off. While there may be significant differences about whether a particular tariff will have a net benefit or cost for the country imposing it, no one disputes that if high tariffs were imposed by all countries, global trade would shrink and we would all be poorer – in fact, a lot poorer.
And yet more global trade may be affected by the level of trade finance than by the level of tariffs. The World Trade Organization (WTO) estimates that 80% to 90% of world trade relies on trade finance.1 That includes credit, guarantees, letters of credit, insurance, and other products. Meanwhile, as of 2016, import tariffs affected just over 8% of G20 exports.2,3 Accordingly, the WTO has announced that it is “seeking to encourage the revival of the complex links and networks involved in the trade finance market in order to keep finance flowing for trade, thereby mitigating at least one reason for the shrinkage of trade flows.”
Here is a recommendation for the WTO: Take a look at post-crisis banking regulation. Global banks play an extraordinarily large role in facilitating global trade. The major reason we have international banks is because we have international companies. Banks follow their customers around the world, where they lend clients money, manage their currency and interest rate risk, provide custody services, and bank their employees. They finance cross-border trades. The largest commercial banks, on the other hand (those with $50 billion in assets or more), wrote approximately $265 billion in standby letters of credit in the first quarter of this year. The volume of these commitments, which are most commonly used in the execution of international trade and other high-value contracts, indicates that the largest banks provide considerable financing toward trade and global economic growth.
Nonetheless, global regulators – to date, mostly U.S. regulators – have enacted post-crisis regulatory regimes to “ring-fence” banks and significantly hinder their ability to serve their clients. In particular, the Federal Reserve has required internationally active banks to cordon off a large part of their operations in the United States, removing much of the efficiency and risk-mitigation benefits of having global operations in the first place. That regime has some benefits because it is designed to reduce some clear risks that presented themselves in the financial crisis, but it also has significant costs. And it has also been applied to entities where there seemingly are no benefits at all. Other jurisdictions are following suit.
This edition of Banking Perspectives contains articles from three respected thinkers in this area: H. Rodgin Cohen, Senior Chairman of Sullivan & Cromwell; William Coen, Secretary General of the Basel Committee; and Wilson Ervin, Vice Chairman, Credit Suisse. They provide background on these important policy issues and some potential solutions.
Post-Crisis Regulatory Tariffs
As each of our authors notes, the push for ring-fencing in the United States stemmed from legitimate concerns during the financial crisis. First, foreign banks operating in the United States were in a substantial “due from” position with their home-country parents because they were a source of dollar funding; when market sources of funding dried up, they then turned to the Federal Reserve’s discount window. Moreover, when the Fed wound down its discount window lending as the crisis eased, a few foreign banks were the last to repay. Second, there was concern that the U.S. operations of foreign entities would be ring-fenced ex post due to lack of support from the home country. The risk of ex post ring-fencing combined with imperfect supervisory cooperation to establish an incentive for each jurisdiction to ring-fence ex ante.
Import tariffs and regulatory tariffs have a lot in common. First, both are designed to serve a national interest: Import tariffs protect local industries by making their products less expensive than foreign imports, boosting domestic businesses; regulatory ring-fencing ensures that foreign banks operating in the United States will not require U.S. taxpayer support. Second, both an import tariff and a regulatory tariff can be advantageous for a first mover: An import tariff will benefit a national industry seeking to grow or defend against foreign competition and is particularly beneficial to developing economies; ring-fencing, as Ervin explains, will benefit a first-mover host country by guaranteeing a local bank adequate resources but still leaving substantial resources freely available at the home-country headquarters to deploy to meet any additional capital or liquidity needs of its local institution.
The final, unfortunate, similarity is the tragedy of the commons: Both import tariffs and regulatory ring-fencing generally prompt a corresponding response, with any first-mover advantage lost and everyone left worse off. Because multiple countries impose import tariffs, competitive advantage is lost, and the only effect is to reduce the volume of trade and its corresponding economic benefits. Similarly, as each host country ring-fences capital and liquidity in its jurisdiction, the resiliency of the firm is reduced; there are no free resources left to support a troubled subsidiary anywhere; and no host is better off. (To use an analogy, the commonly funded fire department is closed when each home decides to rely solely on more-costly, and almost certainly less-effective, sprinkler systems and fire extinguishers.)
There is one difference between regulatory and import tariffs. When presented with the tragedy of the commons, the reaction of many regulators is to provide a simple solution: Just raise aggregate capital and liquidity requirements significantly higher. So, allow every host to ring-fence as much as it likes, and then raise the home-country capital or liquidity requirements so that there is as much capital as ever held at the top tier and available for deployment.
This is an extremely poor solution. There is no dispute that higher capital requirements reduce economic growth, and liquidity requirements come with their own set of costs. Every evaluation of the cost and benefits – including those done by the Bank for International Settlements4 (the parent of the Basel Committee on Banking Supervision), the Federal Reserve,5 the Bank of England,6 the International Monetary Fund,7 and the Minneapolis Fed8 – begin by estimating the decline in lending and economic activity that are caused by higher capital requirements.9 By failing to resolve home-host tensions and simply opting for higher requirements, regulators are hurting economic growth needlessly. Thus, as the articles in this issue illustrate, the push for reconciling home versus host concerns continues.
Ring Fencing and Solving a
As well described by Cohen and Coen, the primary reaction to crisis concerns has been the Federal Reserve’s requirement that foreign banks establish an intermediate holding company (IHC) to conduct most of their U.S. operations, with enhanced capital (including stress testing), liquidity, and risk management standards imposed. This has contributed to the shrinking presence of foreign banks in the U.S. From the third quarter of 2016 (when foreign banks were first required to have IHCs established) to the first quarter of 2018, IHCs reduced their total assets by 10%. Over the same period, U.S. bank holding companies increased their total assets by 3%. Additionally, foreign-owned U.S. broker-dealers shrank by more than half between 2010 and 2017. While ring-fencing is not the sole cause of this shift, it very likely played a role.
These requirements would be more difficult to understand if an entirely separate regulatory regime had not been constructed to satisfy the same concerns. Extraordinary regulatory and bank resources have been devoted to developing and implementing a single-point-of entry (SPOE) resolution regime. As initially conceived, this regime made ring-fencing at host countries unnecessary, given the abundance of holding company loss-absorbing resources available for distribution.
Thus, the core assumption of every such resolution plan (living will) is that while creditors of the holding company are bailed in and absorb loss, all material subsidiaries (domestic and foreign) remain open and operating. Taking Lehman Brothers as the paradigm for risk to host countries from international operations, a central feature of the post-crisis regulatory regime is a legal requirement that a parent holding company like Lehman hold massive loss absorbency at the holding company level, with those creditors clearly in a first (equity) and second (long-term debt) loss position, so that any Lehman subsidiaries around the world could be recapitalized in bankruptcy or resolution. (Not incidentally, the FDIC now has the authority to resolve a parent company like Lehman – authority it lacked in the crisis.) And the purpose of crisis management groups established post-crisis was to ensure cooperation on living wills and engender trust. Imposing ring-fencing on top of these actions seems akin to a country with a trade surplus erecting high import tariffs. Furthermore, it bespeaks a wholesale failure of the Crisis Management Groups to achieve their goal. People happy with their trade balances do not raise tariffs and start trade wars.
As one illustration, the Financial Stability Board mandated that host countries hold internal TLAC – pre-positioned, ring-fenced loss absorbency between 75% and 90% of holding company loss absorbency, with the exact percentage to be determined by Crisis Management Groups. As Cohen describes, this was significantly more than was necessary to achieving the stated goal of internal TLAC: ensuring that home country resolution authorities do not abandon a significant overseas subsidiary and allow it to fail in a disorderly way. Even then, the Federal Reserve in 2016 set the floor at 90% for all foreign banks operating in the United States. Worse yet, by one estimate (and the only estimate we have seen), the other enhanced capital standards imposed by the Federal Reserve have resulted in an average de facto internal TLAC requirement of 140% of home-country holding company requirements.10 This creates a powerful incentive for foreign banks to move assets out of the United States, which is what they have been doing.
Notably, some ring-fencing is not even imposed by host countries. Here again, the U.S. leads (if that is the right word) the rest of the world. Through the living-will process, the Federal Reserve and FDIC have created a secret liquidity regime for internationally active banks that has never received public notice, let alone comment. That regime requires ring-fencing of liquidity at each overseas material subsidiary. Many, if not most, of the affected banks have reported that this regime, not the liquidity coverage ratio, is their binding constraint for liquidity. Similarly, the Edge Act specifically allows U.S. banks to conduct a wide range of activities through special subsidiaries abroad, but usage of that law has been strongly disfavored by the Federal Reserve post-crisis (though there was no crisis-era experience to motivate such action); instead, the Fed has pushed U.S. firms to conduct all their overseas activities in holding company affiliates, effectively ring-fencing those activities outside of their bank subsidiaries.
Even if nothing had been done on resolution, certain aspects of the regime would be difficult to justify. As an example, consider foreign banks operating in the United States through bank subsidiaries. Sixty-two percent of Banco Santander’s domestic IHC’s assets are composed of the activities of two U.S. commercial banks housed under its IHC, Santander Holdings USA, while the rest is generated from a host of other U.S.-based lending businesses. BNP Paribas operates Bank of the West and First Hawaiian stateside, which account for 75% of BNP Paribas’ domestic IHC’s total assets. These subsidiary banks are from any legitimate regulatory perspective indistinguishable from regional banks of the same size. They are subject to the same capital and liquidity regimes, the same examination regime, and, if they fail, they will be resolved by the FDIC in the same way as any other insured depository institution. And yet they have been swept into the Federal Reserve’s IHC regime.
Consider also branches of foreign banks. As Cohen rightly notes, the Federal Reserve did not require branches to be part of the IHC. (Or put another way, the Federal Reserve did not outlaw branching by foreign banks because a branch that is part of a separately incorporated subsidiary simply isn’t a branch anymore.) The justification is clear, as branches are part of their home-country bank, which has their liabilities on its books. For reference, any Office of the Comptroller of the Currency proposal to require U.S. banks to separately capitalize each branch would be seen as bizarre because each branch is on the books of its parent, and its liabilities are the parent’s liabilities. Thus, while there are limits to what activities a foreign bank can conduct through a branch, as a de jure matter, the Fed has not ring-fenced branches of foreign banks.
Alas, de facto kicks the butt of de jure every time. While foreign branches are exempt from the IHC requirement, they remain subject to the Federal Reserve’s combined U.S. operations requirements. A common complaint we hear from foreign banks is that U.S. regulators increasingly are ring-fencing branches – not publicly, by regulation, but secretly, through the examination process. This includes risk management requirements utterly at odds with the notion of consolidated risk management. Think of it as requiring the branch manager for the bank around the corner from you to have her own risk policies, independent of the main bank and its other branches. Some of this effort may be attributable to the same underlying motivations for ring-fencing described above, though it may be part of the larger trend of examination as management consulting. In either event, the effect is the same: a tariff on operating a branch in the United States. (And one that eventually will be imposed by the European Central Bank, the Bank of England, and other global regulators on U.S. banks operating branches abroad.)
In sum, the regulatory and examination regime currently applied to foreign banks operating in the United States seems difficult to justify based on any historical experience or reasoned analysis. Taken individually, each element of the ring-fencing regime may make sense to help address home-host trust concerns that could arise in a crisis. Taken cumulatively, however, they effectively undermine the carefully crafted SPOE resolution regime, and they undercut U.S. economic growth by discouraging foreign bank financing of U.S. activity. Worse yet, they appear unreasonably punitive and protectionist, thereby inviting inevitable retaliation against U.S.-headquartered banks operating abroad. Particularly at a time when the importance of global trade is much in focus, it would seem appropriate for bank regulators to revisit their tariffs. A recent address by Fed Vice Chairman Randal Quarles indicates that he is interested in this topic and receptive to public comment. We hope that this issue of Banking Perspectives will assist him and others willing to take a fresh look. n
1 World Trade Organization. https://www.wto.org/english/thewto_e/coher_e/tr_finance_e.htm
2 Simon J. Evenett and Johannes Fritz, “Will Awe Trump Rules?,” Global Trade Alert, July 4, 2017. https://www.globaltradealert.org/reports/42
3 Brian Caplan, “Trump’s Trade Tariffs Miss the Point,” The Banker, June 26, 2018. https://www.thebanker.com/Comment-Profiles/Editor-s-Blog/Trump-s-trade-tariffs-miss-the-point
Greg Baer is the Chief Executive Officer at the Bank Policy Institute.