U.S. regulation risks a “Balkanization” of cross-border capital
By Henry Engler, Compliance Complete
NEW YORK, Mar. 12 (Thomson Reuters Accelus) – The term “unintended consequences” has often been used by critics of U.S. regulatory reform when characterizing its complexities. While well-intentioned individually, when unleashed in unison the multiple requirements banks that face become highly unpredictable, including across national borders.
What critics emphasize is that it is impossible to know how bank behavior might change when confronted with layers of regulation. Specifically, for foreign banking organizations (FBOs) operating in the United States, three separate pieces of reform will raise the cost of doing business in American markets:
- OTC derivatives reform and the introduction of swaps execution facilities;
- Federal Reserve requirements that each FBO with combined U.S. assets of $50 billion and over will need to establish an umbrella entity dubbed and “intermediate holding company” (IHC); and
- Volcker rule requirements for FBOs on proprietary trading activities in the U.S.
How the management of large FBOs respond strategically remains unclear, but already there is evidence that the global market for cross-border capital is becoming fragmented.
Euro-swap markets become more localized
For example, after the recent overhaul of the OTC derivatives market, there is data showing that European dealers and banks are shunning U.S. markets. Research by the International Swaps and Derivatives Association shows that the October introduction of regulated swap execution facilities (SEFs) as trading platforms has led to a fracturing of the U.S. and European swap markets. Specifically, there has been a sizeable shift of Euro interest rate swap trading to European dealers, many of whom have decided not to register with SEFs, according to ISDA research.
“European dealers have been opting to trade euro-denominated interest rate swaps with other European counterparties since the start of the SEF regime on October 2, 2013. Based on the volume of trades cleared at LCH.Clearnet, approximately 90 percent of European interdealer activity in euro interest rate swaps is now being traded with other European firms, up from roughly 75 percent before October,” said the report.
What has prompted the shift in trading behavior by Europeans? ISDA believes much of the reticence can be traced to “Footnote 88,” an arcane provision of the SEF rules that required all multiple-to-multiple trading platforms to register as SEFs, even if the products they offer are not subject to a mandate that requires trades to be executed on a SEF. A number of non-U.S. electronic trading platforms took the view that they would need to register with the CFTC if any U.S. person – including foreign branches of U.S. banks – traded directly or indirectly on their venue.
“Given the complex registration process, and the need for SEF customers to sign lengthy end-user agreements, a number of non-U.S. platforms decided it was simply easier to ask U.S. participants to stop trading on their platforms, or to split their businesses between U.S. and non-U.S. liquidity pools. The latest ISDA research shows this has become a reality,” added ISDA.
Fed requires FBOs to establish separate “IHCs” in U.S. operations
A second reform raising alarm bells is the Federal Reserve’s recently finalized rule for FBOs on capital and establishment of “intermediate holding companies” for their U.S. operations. Banks that want to maintain a presence in the U.S., a market that represents 55 percent to 60 percent of global investment banking profits, will be forced to ring-fence capital to protect against future financial crises.
The establishment of an IHC will entail restructuring costs related to transaction booking-trade flows, reallocating assets, revising employment contracts, creating additional management and governance structures and systems for calculating and reporting capital and other regulatory standards, modifying information technology systems, and establishing new governance and funding mechanisms.
Deutsche Bank, similar to other big European banks, has already announced that it would have to reduce its U.S. assets by $100 billion because of the Fed’s new requirements. Analysts at Morgan Stanley, in a recent note to clients, wrote:
“The Balkanisation of banking markets will drive starker regional distinctions and participation choices . . . We believe the real challenge lies in the complexity and cost of dealing with multiple subsidiarisation demands across jurisdictions. The interplay of constraints imposed by host regulators in local markets, regulators in key hubs, and home market regulators creates an optimization puzzle that is hard to solve.”
Among FBOs most affected by the rules, the report cited Deutsche Bank and Credit Suisse, with 37 percent and 35 percent of their group assets in U.S. subsidiaries, followed by Barclays (23 percent), UBS (17 percent), HSBC (14 percent), BNP (10 percent), and RBS (9 percent). The chief executive of RBS, Ross McEwan, said in an interview this weekend that higher capital charges in the U.S. was a factor forcing the bank to rethink its investment banking presence in the U.S.
Volcker rule: high costs of compliance
The scope of the Volcker rule’s ban on proprietary trading will affect nearly 150 top-tier foreign banking organizations headquartered in more than 50 countries outside the U.S., and every one of their affiliates, wherever located. How this requirement, and its costs, will impact FBOs and their strategic decisions remains to be seen.
At a minimum, for European institutions, who at home will face their own domestic regulations on “ring fencing” retail from investment banking operations, the Volcker rule is an added layer of complexity that will drive up of the costs of doing business globally. When put in the context of the U.S. requirements noted above, a strategic review of American operations might conclude the need to significantly scale back market making businesses, and devote resources to other regions.
Fragmented markets a price worth paying?
In trying to understand the logic behind rules that are creating incentives for large banks to reduce their global footprint, industry observers say the motivation may be linked to concerns about systemic risk in the event of a future crisis.
“You have an overall trend of ring fencing and subsidiarisation to ensure that legal entities in their respective jurisdictions have enough capital and liquidity to withstand financial shocks,” said Luigi De Ghenghi, a partner with Davis Polk, a law firm in New York.
Given that global regulators have yet been unable to tackle the issue of “too-big-to-fail” in any meaningful way, their attempt to make global operations more costly may be a back-door approach to scaling back large institutions. Such a strategy can yield less efficient markets and higher prices for customers, as well as lower returns for shareholders. These issues appear to be secondary.
“You may prevent systemic failures, but you may also increase the risk of more localized failures,” added De Ghenghi. “But that seems to be the price (regulators) are willing to pay.”
(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)