To Regulate Foreign Banks in the U.S., ‘Trust, but Verify’

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. She is also a faculty member at Financial Markets World.

The Federal Reserve is expected to finalize capital rules for “foreign bank organizations” on Tuesday, and it has reignited questions about whether the United States is being unduly harsh to European banks here.

Absolutely not.

In fact, not only have foreign banks not been required to be sufficiently capitalized to sustain unexpected losses, but also they have been even less capitalized than banks with headquarters in the United States. This means that European banks have been in a position to play regulatory arbitrage and book some of their riskier transactions in the United States. Financial lobbies, such as the Global Financial Markets Association, have been decrying the Federal Reserve rules, and like a weary Greek chorus, repeating their mantra that regulation will cause some foreign banks to leave the United States.

Given the financial weakness of many large systemically important European banks, coupled with accusations of money laundering and terrorism financing, as well as the Libor and foreign exchange scandals, I would like to know when they are leaving and where. If they really do leave, then auf wiedersehen, bon voyage, and vaya con Dios!

The position of United States bank regulators has been that, because European banks were supervised by their European regulators, they could trust what European regulators said. Never mind that this means that the Federal Reserve was outsourcing some of its responsibilities of ensuring the safety and soundness of banks on our soil; the Federal Reserve also hardly extended this trusting standard to foreign bank organizations that were not European.

Fortunately, United States bank regulators are learning that just because something comes from Europe does not make it good. Country risk emanates not only from emerging markets, but also very much from the United States and Europe as well. The Federal Reserve has to impose higher capital requirements on foreign bank organizations because a number of  European banks, including Credit Suisse, Deutsche, Dexia, Royal Bank of Scotland and UBS, received Federal Reserve emergency loans during the global financial crisis. Why did American taxpayers have their money used for this purpose? Why didn’t the European parents take care of their wayward children? They could not.

Now, more than five years since the global financial crisis, most European banks are still reeling from the effects of the eurozone crisis and anemic eurozone recovery. A recent Moody’s study found that “the default risk of significant euro area banks remains elevated relative to the peer group.”

“With nearly 40 percent of European banks’ $3.4 trillion in foreign claims vis-à-vis euro area banks and the largest banks likely accounting for the greatest foreign claims, it is easy to see how significant banks may be viewed as more risky than the peer group for the foreseeable future,” the study said.

The study also found that under stressed economic scenarios, the default risk of significant euro area banks in absolute terms and relative to the peer group was more severe.

A few weeks ago, while at the European Central Bank, my conversations with lawyers and regulators there reinforced my view that regrettably in some crucial regulatory areas, Europeans lag the United States significantly.

First, the European Central Bank will begin supervising directly all European banks only in November 2014. Like with any new venture, this means that the E.C.B. is quite busy with organizational and administrative tasks, not to mention hiring and hopefully training new bank examiners. Unfortunately, the latest E.C.B. stress tests for European banks were largely opaque and certainly not stringent enough. With so many moving parts, no one can afford to assume European examiners can adequately examine European banks in Europe and their foreign subsidiaries, as in the ones in the United States.

Second, although British and European regulators are trying to establish frameworks analogous to the  Volcker Rule, the rules not been finalized and hence are even more delayed in being implemented than they are in the United States. Moreover, neither the Vickers Commission in Britain and the Liikanen Group in the European Union expressly prohibit a consolidated bank from engaging in proprietary trading.

As Daniel K. Tarullo of the Federal Reserve pointed out in early February in his testimony before the House  Financial Services Committee, British and European reforms “bear closer resemblance to the traditional U.S. banking structure concept of ring-fencing depository institution subsidiaries of bank holding companies.” Essentially, this means that European banks can still conduct proprietary trading, and the bank entities are not necessarily separated from the risk of these activities.

Last, the European Bank Authority, which has a mandate to be responsible for resolving banks in case of a failure of Europe, is at a nascent stage. It is still staffing up. Its funding level and even the source are unclear. Additionally, unlike the Financial Stability Oversight Council in the United States, which has a developing Office of Financial Research that collects and analyzes data useful to determine where the next systemic risk, the European Bank Authority’s efforts to establish a comparable group in Europe lag significantly. If a European bank were to fail tomorrow, it is most doubtful that the European Bank Authority could conduct an orderly liquid authority of one of its banks. Even more unclear is where that would leave that bank’s subsidiaries and branches in the United States.

The European Central Bank’s supervisory group and the European Bank Authority continue to establish themselves, European and American taxpayers are still exposed to those European banks that are by and large unhealthy. Data collection problems and opacity by banks both in the United States and Europe abound. Yet, even working with the unreliable data that we have, European banks remain undercapitalized compared with American  ones.

European banks also have another significant problem battling lawsuits because of a long list of charges. Given how difficult it is to define, identify, measure, control and monitor operational risk, which encompasses infractions like money laundering and benchmark rate manipulation, it is unlikely that European banks being investigated for all these scandals are sufficiently capitalized.

This alone justifies that foreign bank organizations must have rigorous capital standards, no matter where they have their headquarters. It may sound very Gorbachev-Reagan to say ‘trust but verify,’ but to protect American taxpayers, United States bank regulators must take that Soviet-era saying to heart