Federal Reserve Clashes With European Central Bank Over Bank Capital Reserves

At the height of the financial crisis in 2008, foreign banks, instead of American banks, were the biggest recipient of funds from the Federal Reserve discount window -- known as the lender of last resort. Given the change in the role that foreign banks play in the U.S., regulators are taking radical steps to ensure that U.S. taxpayers will be protected if financial institutions from other countries fail in the future.

According to Fed data, overseas banks accounted for about 70 percent of discount window loans when borrowing reached its peak of $113.7 billion in October 2008. These foreign lenders didn’t have to meet Fed capital rules to cover losses on American-based units provided their parent company was properly capitalized.

The U.S. central bank plans to force higher capital requirements on the U.S. subsidiaries of European banks, a proposal seen by Michel Barnier, the European Union’s financial services chief, as a threat to harmonious global regulation and risks “a protectionist reaction,” according to the Financial Times.

“We fear that [the rules] could spark a protectionist reaction from other jurisdictions, which could ultimately have a substantial negative impact on the global economic recovery,” Barnier warned in a letter to Fed Chairman Ben Bernanke, adding that “these developments would translate into higher costs for banks, particularly those which are internationally active.”

He warned that retaliation could “end up with a fragmentation of global banking markets.”

Under the new rules, which could come into effect this year, large foreign banks operating in the U.S. would need to ensure that their subsidiaries meet a minimum threshold of seven percent core capital to risk-weighted assets.

The aim is to protect the U.S. taxpayer if a global bank collapses, Daniel K. Tarullo, the Fed governor responsible for bank supervision, said in a speech at Yale University in November. “Our regulatory system must recognize that while internationally active banks live globally, they may well die locally.”

A senior U.S. official rebuffed the letter by the EU's Barnier, saying that Brussels sometimes appeared more concerned about protecting the competitiveness of its banks than the safety of the financial system, a Financial Times article said. A Fed spokesman told the Wall Street Journal that the Fed’s proposals were in response to the changing risks posed by large foreign banks to U.S. financial stability, and pointed out that the U.K. already has similar capital and liquidity requirements on its book. A number of these firms rely on “potentially unstable” short-term funding and have seen rapid growth in their capital markets businesses, the spokesman said.

The role foreign banks play in the U.S. has changed in recent years. Through the 1990s, most borrowed from their parent companies to lend in the U.S. and had excess cash reserves to meet local requirements. The trend reversed early last decade, when foreign companies started borrowing in the U.S., to lend overseas. Their trading in the U.S. surged to 50 percent of assets in 2011, up from 13 percent in 1995, Tarullo said.

In testimony to Congress last week, Scott Alvarez, the Fed’s general counsel, noted that if foreign banks are “allowed to compete in the U.S. without the same capital requirements and without the same prudential limits that apply to other U.S. organizations in the U.S., that could give the foreign entities a competitive advantage here, as well as exposing our system to more financial risk.”

At the moment, large banks are usually judged on their aggregate international level of capital, allowing foreign lenders, such as Deutsche Bank AG (NYSE: DBD), to offset its more weakly capitalized U.S. business against its stronger German operations.

Barnier is urging Bernanke to adjust the implementation so that jurisdictions with “equivalent” prudential rules, such as the EU, are exempt and can supervise a bank’s consolidated global operations from its home country.

European banks remain undercapitalized compared with their U.S. rivals. Moreover, while the Germany government would most likely regard Deutsche Bank as too big to fail in the event of a liquidity squeeze, the euro zone debt crisis has limited the government’s ability to move.