The Fed Faces Foreign Banks

Federal Reserve Chair Janet Yellen oversees Tuesday’s meeting. Source: Getty Images/Alex Wong.

The Fed issued new rules this week creating specific capital standards for foreign banks operating in the US. While some have said the Fed’s move is the beginning of the “Balkanization of global finance,” we’d suggest that’s a stretch. But they could interfere with ongoing US-EU free trade talks—not an imminent negative for stocks (unless this escalates into a full-blown trade spat), but jeopardizing a potential long-term positive.

Prior to Tuesday’s rule release, foreign banks’ US-based branches weren’t subject to specific capital requirements as a condition of operating on US soil. Instead, their capital was considered under their home country’s banking regulations. Yet this became something of a political hot potato in the US, as many foreign banks sought emergency loans from the Fed during the 2008 financial crisis. So 2010’s Dodd-Frank Wall Street Reform and Consumer Protection Act sought to squash this, giving birth to the concept that became the new rule.

In theory, the new rule seeks to reduce the chances American taxpayer dollars backstop (even temporarily) foreign Financials. Starting July 1, 2016, foreign banks with $50 billion or more in assets will have to combine subsidiaries under one US holding company, which must then establish “risk committees”—headed by an independent director—to monitor risks across the firm. They’ll also have to meet US capital standards. Additionally, all foreign firms with $10 billion or more in assets will be subject to Fed stress tests.

The rules aren’t a surprise—as with nearly all of Dodd-Frank, they’ve been in the cards for years, have been discussed ad nauseam and are actually watered down a touch from initial proposals. But, as usual with regulations, they likely create winners and losers. The rules only apply to bigger banks—smaller banks get a pass, essentially creating an incentive for foreign banks to limit their US presence. Those that do keep a larger presence may face a tough road. Some previously operated with little capital in their US affiliate—US-based assets were accounted for and capitalized in home countries. Now all impacted banks will have to hold capital on US soil. While the Fed suggested some banks could meet the requirement by retaining more US earnings or shifting funds from parent companies, some firms likely have to raise funds via debt or equity issuance, or just deleveraging—a task they perhaps wouldn’t take on otherwise.

How foreign governments respond remains to be seen—particularly, the European Union (EU). The EU and US are currently negotiating the Transatlantic Trade and Investment Partnership (TTIP), which aims to free the movement of goods, services and capital across the pond. Both sides claim to want a transatlantic financial services market, with common (more or less) regulations. This rule seems to cut against that general theme. EU market commissioner Michel Barnier’s response said it all: “I think it’s a shame that we are not advancing with a multilateral approach,” which was already under discussion at multiple levels, including TTIP. It would seem safe to say the EU likely sees this as a bit of a stumbling block to that broad agreement.

The TTIP is one of those giant trade agreements that typically take years to hash out, and a deal that is already facing tough sledding. Likely to curry favor with constituents ahead of midterm elections, Senate Majority Leader Harry Reid came out against “fast track” trade approval, widely seen as necessary for any big deal to pass Congress. Fast track requires Congress to submit their requests and requirements to trade negotiators up front, then put the final deal to an up-and-down vote without any amendments. Fast track allowed Congress to ratify several recent deals (e.g., Colombia and South Korea), but Reid indicated it won’t come up in the Senate any time soon—not surprising, since free trade is a tough sell with many Americans, but likely also not permanent given how high President Obama claims trade is on his agenda. But the likely delay does make negotiators’ year-end 2014 target for an agreement, seem awfully optimistic—especially given other extant roadblocks, including other differences over investment protection and agricultural standards.

Now, that isn’t so much a negative as it is the absence of a potential, long-term positive (freer trade if TTIP came into being). Depending on how things go, however, this could introduce bigger negatives downstream. It’s very unlikely, but if the EU reacted more harshly—erecting its own barriers to US banks doing business abroad—a Financial sector trade spat could develop. These barriers hurt both sides. On one hand, they hurt banks—foreign operations might comprise a small portion of banks’ overall business lines, but revenues are revenues. On the other, it hurts economies on the receiving end. Consider just the narrow effect of the new rule: Foreign-affiliated banks account for about 9% of all US lending. If these new regulations get in their way, there is no guarantee domestic banks will fill the shortfall. And the people ultimately hurt could be borrowers, who would see either higher costs from less competition or just less access to credit. More broadly, countries’ squabbling over trade measures (and that is what these rules amount to) can be disruptive for global trade, a potential negative worth watching given the many other agreements in progress globally, like the Trans-Pacific Partnership. These don’t need another wrinkle.

At this point, this likely won’t materialize into anything more than slightly higher barriers to free-flowing capital and a headwind for those foreign banks with a larger presence in the States. Spokespeople for Deutsche Bank and Barclays said each bank is reviewing the final rule, and given the extended timeline, they don’t see any issues. That said, events like Tuesday’s Fed rulemaking can have broader implications, potentially creating headwinds for freer trade longer term—something investors should keep in mind.