Daniel K. Tarullo, Federal Reserve Governor, and chairman of the Federal Financial Institutions Examination Council, discussed cross-border regulatory models and his proposed method of shared regulatory responsibility in his speech titled “Shared Responsibility for the Regulation of International Banks” given at “The Future of Large and Internationally Active Banks,” 18th Annual International Banking Conference on November 5, 2015.1 Tarullo discusses cross-border banking models and the governing regulation before considering potential causes for the financial crisis, and finally offers his perspectives on effective cross-border banking models and regulation.

Cross-border banking models risks and rewards

For Tarullo, cross-border banking refers to the activities conducted outside a bank’s home country through its subsidiaries and branches. Innovations in this international banking system trigger regulatory responses, which in turn, create the need for adjustments in financial activity. The dynamic nature of regulation and international banking activity, Tarullo argues, raises the question of who should be responsible for the regulatory changes that drive such behavior and what kind of regulation is appropriate in such an environment. In response, Tarullo outlines the following key challenges:

  • There is a level of idiosyncratic risk involved that often varies based on the size and sophistication of the parent bank; however, any country’s market is susceptible to periods of idiosyncratic or generalized stress.
  • The parent’s capacity to support its foreign operations in the event of a reversal in the home market or in its foreign operations is a potential risk. The response of the parent company to financial stress may also hurt foreign operations by exacerbating activity in foreign markets.
  • Failure of a host jurisdiction environment is also of concern, as the parents must decide whether to invest resources in trying to help the bank or to let it fail. A failure would put significant stress on the host country’s financial system, and possibly the global markets.

Tarullo outlines four cross-border banking models:

Model Description Risks Rewards
Home jurisdiction The home jurisdiction has dominant or exclusive regulatory responsibility for all of its banks and global operations ·   Most responsive to the impact of regulation to its own market

·   Likely to undervalue the potential risks and costs of regulation for host countries

·   In periods of stress, would concentrate on stabilizing its own markets and could, at worst, lead to foreign operations to default

·   Quickest deployment of capital and liquidity where it is most in demand

·   Minimizes compliance costs

·   Centralized regulatory authority

Host jurisdiction The host jurisdictions have dominant regulatory responsibility for all banking activity within its borders ·   Cost of entry is very high

·   Still not protected from suffering some contagion if the parent is under stress

·   Likely to be more attentive to the risks posed to its financial system

·   Best positioned to set regulatory and supervisory framework that meets its regulatory needs and local requirements

·   Minimizes the risks of abrupt shifts of capital and liquidity out of the country

Shared authority Host jurisdictions do some regulating and supervising of banks within their borders ·   Host country regulators do not exercise prudential oversight of all foreign bank activities

·   Home country regulators prioritize home country regulatory interests

·   Host jurisdictions have better insight as to the regulatory and supervisory framework that will best meet its regulatory needs and local requirements

·   Centralized regulatory authority to hold accountable

Global regulator One global regulator oversees all of the operations of internationally active banks around the world ·   Difficult to balance all competing interests

·   How is the regulator held accountable

·   Account for all interests

Evolving regulatory principles and guidelines in the cross-banking system

The financial crisis of 2007-2009 drew attention to the inadequacy of existing home and host country regulation, as well as the inadequacy of the rules governing capital and other requirements.  The cross-border nature of most large banks amplified these issues in an environment where regulations where augmented instead of reassessed for lack of appropriateness. Strong measures, such as increased enforcement powers, further compounded the complexity of the symptoms while not addressing root cause issues related to outdated regulatory assumptions and methods.

The following regulatory changes raised by Tarullo during his speech specifically focus on the relationship of the home country to the cross-border banking system:

  • Basel III regulation improved the quantity and quality of capital requirements and also introduced G-SIB (global systemically important bank) capital surcharges. Tarullo notes that the rules governing the G-SIBs allow the parents some flexibility, as G-SIBs do not apply to FBOs (foreign banking organizations) in their jurisdictions.
  • Similar prudential requirements are adjusted to consider the relative importance of the FBOs in the US financial system, this he feels assures financial stability while allowing the home jurisdiction to realize the benefits of global banking.
  • Consolidated supervision, whose intent is to ensure that were a home bank to fail, its global operations would remain stable and contain possible risk to other foreign operations, is still an accepted principle among regulators. However, Tarullo advocates that the regulation imposed by the home jurisdictions is just as, if not more, important. Home jurisdictions, while assuming responsibility for their market’s stability, are also responsible for ensuring enough stability and strength to support its global operations. This responsibility is not in lieu of host country regulation and supervision, but serves in addition to it.

In his speech, Tarullo also touched on the following pieces of regulation that specifically focus on the relationship of the host jurisdictions to the cross-border banking system and capital absorbency:

  • The Dodd-Frank Wall Street Reform and Consumer Protection Act put forward the principle that a host’s regulatory responsibility increases with the size and significance of the jurisdiction’s financial market.
  • The Basel Committee on Banking Supervision has “set out expectations for host country prudential oversight of foreign banks that would be similar to that for domestic banks,” expanded their expectations for the host country’s prudential oversight of foreign banks to a level that is similar to that of domestic banks.
  • Tarullo’s expectation is that the Financial Stability Board’s (FSB’s) framework for total loss absorbing capacity (TLAC) will  incorporate the principle of an extra buffer of loss absorbing capacity at the consolidated level , and this beyond the possible requirements at the aggregate local levels.

Tarullo also advocates for the use of effective monitoring mechanisms to supplement the enhanced regulatory standards in the cross-banking system. He cites the success of the Basel Committee from interactions between key regulators on current topics, while noting the high participation rates of the FSB. As such, he hopes to emulate a model similar to the Basel Committee while achieving participation similar to that of the FSB. He realizes this may not be possible and concludes that ad hoc meetings would be sufficient. His ultimate goal is to encourage the sharing of information on a regular basis in order to assess cross-jurisdiction vulnerabilities and discuss regulatory changes and/or concerns.

Opportunities to improve

While the cross-banking system has undergone much regulatory change since the last financial crisis, there are still risks in the international banking system. Nevertheless, both the home and host jurisdictions are responsible for maintaining balance within the shared regulatory responsibility model that Tarullo supports. He cautions that while increased strength and stability in host jurisdictions may be a sign to implement limited oversight, any failure could not only re-intensify supervision but also cause the home jurisdiction to impose new requirements.

Thus, he notes the importance of tradeoffs as banks hope to capture the rewards of international banking while also maintaining financial stability within global markets. Balancing strong prudential standards with trusted relationships among regulators, Tarullo advocates, is the key to a successful shared responsibility regulatory model.

References

  1. Governor Daniel K. Tarullo, Speech at “The Future of Large and Internationally Active Banks.” November 5, 2015. Access at: http://www.federalreserve.gov/newsevents/speech/tarullo20151105a.htm

Total Loss-Absorbing Capacity, Long-Term Debt, and Clean Holding Company Requirements for Systemically Important U.S. Bank Holding Companies and Intermediate Holding Companies of Systemically Important Foreign Banking Organizations; Regulatory Capital Deduction for Investments in Certain Unsecured Debt of Systemically Important U.S. Bank Holding Companies,” Federal Reserve System, Notice of proposed rulemaking, 12 CFR Parts 217 and 252, Regulations Q and YY. Access at: https://www.federalregister.gov/articles/2015/11/30/2015-29740/total-loss-absorbing-capacity-long-term-debt-and-clean-holding-company-requirements-for-systemically.

Newsletter Author: Venetia Woo; Jennifer Zink

Newsletter Contact Person: Craig Unterseher

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