WASHINGTON — A Federal Reserve proposal to better regulate foreign banks in the U.S. would also significantly expand the central bank's oversight of foreign broker-dealers, effectively snatching supervisory responsibility from the Securities and Exchange Commission in the process.
The Fed's power grab was one of the most striking aspects of the December proposal, which already represented a large shift in how the central bank plans to supervise foreign banks, and suggested a lack of confidence in the SEC's existing oversight of broker-dealers.
"This rule is the Fed bringing the foreign bank broker-dealers into the Fed umbrella," said Margaret Tahyar, a partner with the law firm Davis Polk & Wardwell. "I think one regulator they are mistrustful of here is the SEC."
The Fed's plan is aimed at fixing the flaws in oversight of foreign institutions that were exposed by the financial crisis. (The central bank released a separate proposal in 2011 targeting U.S. bank holding companies.)
In the run-up to the crisis, foreign banks veered away from their traditional lending activities, moving toward more complex, capital market practices. Many began relying heavily on short-term wholesale U.S. dollar funding, which ultimately prompted destabilizing runs.
Some observers have said the SEC, which oversees all broker-dealers, may be at least partly to blame. Its net capital rule is seen as a driver of the crisis, allowing large investment banks like Bear Stearns, Goldman Sachs and Lehman Brothers to dramatically increase their leverage. The rule, which was revised in 2004 to allow certain haircuts, regulates the ability of broker-dealers to meet their financial obligations to customers and other creditors.
In the aftermath of the crisis, five of the largest U.S. broker-dealers are now owned by foreign banks. Similar to their U.S. counterparts, large foreign-owned U.S. broker-dealers had become "highly leveraged and highly dependent" on short-term funding in the years leading up to the crisis, according to comments made by Fed Gov. Daniel Tarullo at the Dec. 14 Board meeting releasing the central bank's plan.
It is a problem the Fed, particularly Tarullo, wants to correct. Of the 107 firms that will be affected by the new proposal, observers said roughly a dozen firms, which own the largest broker-dealers in the U.S., will feel the biggest impact of the new plan, including Deutsche Bank, Barclays Capital, and Credit Suisse.
"We would be negligent if we did not adapt our oversight of foreign banking operations that include these very large broker-dealers, as we have our domestic bank holding companies," Tarullo said at the meeting.
Observers said the move is clearly directed at the SEC.
"This is a bit of poke in the eye at the SEC," said a partner at a law firm, who requested anonymity, because of the sensitive nature of the matter. "In Tarullo's speech and in the preamble, one of the concerns they have is the leverage they perceive to have been built up in the broker-dealer affiliates, which were not subject to Fed capital regulation."
The Fed's proposal will allow supervisors to impose capital requirements on a broker-dealer through a U.S. intermediary holding company, while also giving it an early look at the entity in the event of a failure.
"This IHC superimposes capital regulation on the large broker-dealers, which is another way of the Fed saying it doesn't think the SEC's net capital rule is good enough," said the partner.
A spokeswoman for the SEC did not immediately respond to requests for comments.
What's striking to some is how the Fed crafted the proposal in such a way that an intermediary holding company is treated like a bank holding company regardless if it owns an actual bank. In addition to capital requirements, an IHC would also need to meet certain liquidity buffers and undertake stress testing exercises.
"The proposed rule would generally treat an IHC like a U.S. bank holding company irrespective of whether it owns a depository institution in the U.S," said Andrew Gladin, a partner at Sullivan & Cromwell's financial institutions and corporate and finance groups. "Thus, the foreign bank and its IHC would be subject to bank holding company capital requirements with respect to, for example, it's U.S. broker-dealer subsidiary and funding vehicle, even though it does not actually own a bank."
For regulators, the financial crisis revealed limitations on the ability of some foreign banks to act as a source of support to their U.S. operations under stressed conditions, raising the possibility that should foreign bank offices in the U.S. experience financial problems, they could have a hard time convincing their parent bank to obtain the financial support they may need.
Governments — here and abroad — also appear more reluctant to serve as a backstop to their largest financial institutions, with many countries taking steps to limit their support to U.S. operations. Supervisors additionally face the challenge of cross-border resolutions, which remains a work in progress.
"Looking at it from the Fed's perspective, if they're going to be blamed if some big broker-dealer affiliated with a foreign bank goes down, they want to have a supervisory chance to avoid it in advance," said Tahyar.
The creation of the IHC would solve that problem by helping regulators perform an orderly liquidation and wind down if necessary through that structure.
Firms would have to meet a threshold of more than $50 billion of globally consolidated assets to place their operations in the IHC, which would include their broker-dealer subsidiaries. A foreign firm's U.S. branches and agencies will not be required to be part of the holding company avoiding a full subsidiarization of the company.
At the December Board meeting, Fed Gov. Sarah Bloom Raskin hailed the structure of the IHC as a "huge plus, because it gets supervisors out of the hornet's nest of resolution issues that could arise for a global financial institution."
"The U.S. intermediate holding company would provide the Federal Reserve, as the umbrella supervisor of the U.S. operations of foreign banks, a platform to implement a consistent supervisory program across U.S. subsidiaries," said Raskin. "And importantly, the U.S. intermediate holding company could also help facilitate the resolution or restructuring of the U.S. subsidiaries of a foreign bank by providing one top-tier U.S. legal entity that would be the entity pursuing to which to the resolution or restructuring in the U.S. would occur."
Under such an approach, if a failure were to occur at one of the foreign bank's U.S. broker-dealer subsidiaries, for example, regulators wouldn't have to seek out the foreign parent to determine how to contain the failure. Rather, the U.S. intermediary holding company would act as the domestic platform where regulators could look for capital support without having to go to the foreign parent.
But observers noted that such a plan appears to undermine ongoing efforts by the Federal Deposit Insurance Corp. when it comes to its resolution planning efforts.
The FDIC has expressed its preference for a single-point of entry for resolving internationally active institutions, whereby regulators would be able to come up at the top of the institution and move operating subsidiaries into a bridge bank holding company that could then be recapitalized without significantly deteriorating the quality of the subsidiary operations.
"One of the issues with the Fed's proposal on the application of Sec. 165 to foreign banking organizations is that the Fed even seems to not agree with single point of entry," said Hugh Conroy, counsel at Cleary Gottlieb. "Now, here we have the Fed saying 'When we ask the foreign banks to create an intermediate holding company, that's going to help resolution planning in the U.S.' because they imply that the IHC will be an entry point to preserve or resolve the U.S. operations. That is completely inconsistent with the idea of single-point of entry at the top-tier foreign owner, given that the idea of single point of entry is to move the subsidiaries into a more capitalized bridge institution that could then support its subs in a better way."
But an FDIC spokesman said the agency does not have a problem with the Fed's approach, calling the plan a "net positive" because it will help prevent foreign institutions from hurting the U.S. financial system.
"We don't see the Fed's plan as inconsistent with our resolution strategy because the proposal is taken from a supervisory perspective rather than from a resolution perspective," said Andrew Gray, the FDIC's chief spokesman.