by Derek M. Bush, Partner, Cleary Gottlieb Steen & Hamilton
One of the most controversial elements of the Federal Reserve Board’s implementation of enhanced prudential standards for foreign banking organizations is a new structural requirement. The final rule requires FBOs with $50 billion or more in U.S. non-branch assets to restructure the ownership of their U.S. subsidiaries into a single “intermediate holding company,” regulated as a U.S. bank holding company whether or not it owns a U.S. bank.
Some commenters have characterized the IHC requirement as a dramatic departure from historical U.S. approaches to cross-border banking supervision and regulation; former Rep. Spencer Bachus in a March 14, 2013 letter described it as having “eradicated decades of codified law and regulatory practice in international banking,” It certainly stands out as a noteworthy decision in the FRB’s post-financial crisis policymaking.
The IHC requirement represents a subtle but profound change in policy toward cross-border banking, with consequences that are farther reaching and of broader relevance than the more obvious and intentional departures from past practice (such as eliminating organizational variation and imposing bank regulatory capital requirements on activities conducted through nonbank subsidiaries). The FRB explicitly notes that it based the requirement on changed goals, such as reducing reliance on parent bank/home country support. However, the requirement marks a distinct shift, which this article will put into an historical context, away from the U.S. policy of parity between foreign and domestic banks in similar circumstances, known as “national treatment.”
Historical Approaches to U.S. Regulation of Foreign Banks
Four key milestones mark the development of U.S. federal regulation of foreign banks before the most recent financial crisis: the International Banking Act of 1978 (PDF), the Foreign Bank Supervision Enhancement Act of 1991, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, and the Gramm-Leach-Bliley Act of 1999. Each changed the structure and extent of foreign bank regulation in different and meaningful ways, and yet all four were guided by the principle of national treatment for foreign banks.
The International Banking Act of 1978
The IBA established the foundation for modern U.S. regulation of foreign banks. Until the late 1970s, the bank regulatory framework for most foreign banks’ U.S. operations derived largely from state bank powers and licensing laws. Unless a foreign bank controlled a U.S. bank subsidiary, it generally was not subject to Bank Holding Company Act limitations on nonbank activities and investments or subject to restrictions on interstate branching. As foreign banks’ presence in U.S. markets grew during this period, a concern emerged that this lack of regulation created a competitive advantage for foreign banks. At the same time, it became apparent that a largely state law-based regulatory regime for foreign banks did not afford foreign banks the full benefits of the U.S. “dual banking system.”
The IBA overhauled the U.S. regulatory framework for foreign banks operating through branches in the United States, bringing them under centralized federal oversight by the FRB for the first time. These foreign banks became subject to
BHC Act (PDF) restrictions on nonbanking activities and investments in the United States and restrictions on interstate expansion (with grandfathering of existing operations). Branches also became subject to federal law reserve requirements. (note: In this article, we have not distinguished between branches and agencies of foreign banks, as the distinction is not relevant to the analysis.)
At the same time, the IBA created new opportunities for foreign banks by allowing branches to obtain FDIC deposit insurance for retail deposits8 and by allowing foreign banks to obtain a federal branch license from the Office of the Comptroller of the Currency.(IBA, Sec. 4) Federal branches were to be subject to the same powers and restrictions as national banks, with some exceptions, such as an adjustment allowing restrictions based on capital stock and surplus (e.g. lending limits) to be based on the consolidated capital stock and surplus of the foreign bank (IBA, Sec. 4b) The IBA also authorized the OCC to waive U.S. citizenship requirements for national bank directors (up to a minority of the directors) for national banks owned by foreign banks. (IBA, Sec. 2)
Congress’ explicit guiding principle behind the IBA’s approach to foreign bank regulation, endorsed by the FRB at the time, was a non-discrimination principle of “national treatment and equality of competitive opportunity.” (At various times, national treatment and competitive equality have been articulated as two principles or parts of one principle, and in some contexts one but not the other is mentioned). The IBA’s concept of national treatment, as it has been understood at least since 1978, entails “parity of treatment between foreign and domestic banks in like circumstances.” As a policy objective, national treatment is designed not just to promote fairness but also to improve availability of financial services and competition in banking markets, according to remarks of William J. McDonough, President of the Federal Reserve Bank of New York, March 23, 1996. National treatment also facilitates U.S. banking organizations’ ability to expand into non-U.S. markets where they would expect comparable national treatment to be applied to them, and strengthens the U.S. government’s hand in free trade and other treaty negotiations over access to local financial services markets for U.S. banks.
As illustrated by the IBA, national treatment is a double-edged sword. It gives foreign banks the benefits of opportunities available to domestic banks, but it imposes restrictions designed to be comparable to those that apply to domestic banks, taking into account applicable differences in circumstances.
Foreign Bank Supervision Enhancement Act of 1991
Congress passed FBSEA in the wake of the collapse of Bank of Commerce Credit International and a scandal involving Banca Nazionale de Lavoro, and following the savings and loan crisis of the late 1980s and a number of significant commercial bank failures in the same period. The FRB requested from Congress, and received, broad new supervisory authority over foreign banks, including a requirement that all new branches (whether state or federally licensed) obtain prior FRB approval under newly tightened statutory standards, including that foreign banks be subject to comprehensive supervision or regulation on a consolidated basis by home country authorities (FBSEA 202). FBSEA also gave the FRB direct examination authority over both federal and state branches of foreign banks (FBSEA 203a).
In a provision tracking a similar development for FDIC-insured state banks, FBSEA also limited the powers of state-licensed branches by providing that no state-licensed branch could engage in activities not permitted for a federal branch, and subjected state branches to the same lending limits as federally licensed branches (FBSEA 202a). FBSEA also curtailed foreign banks’ ability to establish branches authorized to take FDIC-insured deposits, grandfathering the relatively small number of existing FDIC-insured branches. (FBSEA 214a)
Of particular relevance to the FRB’s later consideration of the IHC requirement, FBSEA required the Treasury Secretary and the FRB to study “whether foreign banks should be required to conduct banking operations in the United States through subsidiaries rather than branches" (FBSEA 215). In their report following the study (the “Roll-up Study”, Department of the Treasury and FRB, “Subsidiary Requirement Study,” Dec. 1992), the Treasury Secretary and the FRB recommended against such a requirement, in part because it would be inconsistent with national treatment. (See roll-up study at 4). The study confirmed that any branch roll-up requirement (now known as subsidiarization) would require a change in law.
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
Unlike the IBA and FBSEA, Riegle-Neal did not target foreign banks’ U.S. operations. On the contrary, Riegle-Neal’s relaxation of restrictions on interstate banking and branching was designed primarily to reduce restrictions on U.S. banking organizations. Consistent with the national treatment principle, Congress provided for comparable treatment for foreign banks operating branches in the United States, allowing foreign banks to establish branches outside of their home states under circumstances similar to the ones required for U.S. banks to branch across state lines. This required some adaptation, through the FRB’s rulemaking process, to take into account structural differences between foreign banks and U.S. banks, including the fact that interstate branching would involve establishment of an additional branch by the foreign bank (not one U.S. branch establishing another branch in another state).
Although Congress designed the foreign bank provisions of Rielgle-Neal to be consistent with national treatment for foreign banks, there were stages in the legislative process when that outcome was less clear. The Kentucky Bankers Association led an effort, which succeeded for a time in the Senate, to require that foreign banks roll-up their U.S. branches into bank subsidiaries in order to branch across state lines. The Treasury Secretary weighed in against the provision based on concerns that it would be inconsistent with national treatment and could invite retaliation against U.S. banks abroad, according to a letter from Treasury Secretary Newman, dated Feb. 22, 1994. The proponents of the roll-up requirement argued that it was necessary to preserve competitive equality, because in order to branch across state lines U.S. banks by necessity were required to be organized as separately incorporated and capitalized banks.
What this argument ignored, however, is the feature of national treatment that requires comparable treatment of U.S. and foreign institutions “in like circumstances.” By defining the non-discrimination equation in a way that ignored the character of a foreign bank’s operations, and forcing foreign banks to restructure their operations into a U.S. subsidiary model, the proponents of the roll-up requirement had oversimplified the national treatment equation. They essentially argued that comparable treatment required a comparable structure, which was inconsistent with the concept of national treatment in previous legislation and the Roll-up Study. Ultimately, the provision was eliminated in conference committee, and national treatment as it traditionally had been understood was preserved.
Gramm-Leach-Bliley Act of 1999
Like Riegle-Neal, GLBA and its provisions allowing qualifying BHCs known as “financial holding companies” to engage in an expanded range of financial activities were designed mainly to reduce restrictions on domestic banking organizations. Consistent with the principle of national treatment, GLBA also made these advantages available to FBOs. In general, the task of extending these benefits was more straightforward in GLBA than in Riegle-Neal, because the structural differences between U.S. BHCs and FBOs did not significantly matter in the expansion of activities related to U.S. nonbank subsidiaries and investments.
GLBA’s criteria for an FBO to qualify as an FHC required some interpretation. The criteria for U.S. BHCs were based on the “well managed” and “well capitalized” status of their U.S. bank subsidiaries, but the relevant tests needed to be adapted to foreign banks with U.S. branches and agencies. GLBA directed the FRB to apply “comparable capital and management standards to a foreign bank that operates a branch … in the United States, giving due regard to the principle of national treatment and equality of competitive opportunity.” (GLBA 103(a), 12 U.S.C. § 1843(l)(3)).
In implementing this provision of GLBA, the FRB determined to look primarily to foreign banks’ home country consolidated capital to determine whether they were “well capitalized” and to their U.S. branch supervisory ratings to determine whether they were “well managed.” This represented an adaptation from the U.S. standards, but it was viewed as consistent with national treatment, taking into account the different circumstances of foreign versus domestic banks (see See 65 Fed. Reg. 3785, 3788 (Jan. 25, 2000) (interim rule); 66 Fed. Reg. 400, 408 (Jan. 3, 2001) (final rule).
Dodd-Frank Act and Enhanced Prudential Standards
On its face, the statutory language of the enhanced prudential standards provisions of Dodd-Frank Act section 165 appears to align neatly with the milestones reviewed above. It authorizes the FRB to develop EPS in the areas of risk-based and leverage capital, capital planning and stress testing, liquidity, risk management, and single counterparty credit limits, for both U.S. BHCs and FBOs that meet applicable size thresholds. In the case of FBOs, the FRB is required to “give due regard to the principle of national treatment and equality of competitive opportunity,” (Dodd-Frank Act § 165(b)(2)) a standard that tracks the comparable GLBA provision. For this reason, among others, foreign banks generally expected that the implementation would involve a typical exercise in adapting U.S.-based EPS to the cross-border nature of foreign banks operating in the United States. For example, by analogy to the IBA’s federal branch lending limit provisions, FBOs expected that a single-counterparty credit limit for foreign banks would look to aggregate exposures of a foreign bank’s U.S. operations measured as a percentage of the foreign bank’s consolidated capital and surplus.
The FRB’s EPS Rule and the IHC Requirement
Some aspects of the FRB’s regulation implementing section 165 followed this expected path for applying the U.S. national treatment principle, consistent with historical U.S. approaches to similar requirements. Some, including the IHC requirement, did not.
When FRB Governor Daniel Tarullo foreshadowed the IHC requirement in
speech at Yale University in November 2012, he specifically referred to the U.S. policy of national treatment, which he defined as treating a “foreign-owned service provider no less favorably than like domestic service providers.” Tarullo noted that “of course, differences in business organization, domestic regulatory systems, and other factors mean that there must sometimes be determinations whether foreign and domestic firms are ‘like’ one another in relevant respects.” In the rulemaking process, however, the issue of national treatment, and the question of “like” foreign and domestic firms, became a particular topic of controversy in relation to the IHC requirement.
As implemented, the IHC requirement requires FBOs with $50 billion or more in total U.S. non-branch assets (assets in essentially all U.S. subsidiaries) to restructure the ownership of their U.S. subsidiaries into a single U.S. IHC. The IHC would be supervised and regulated by the FRB, and subject to EPS as well as ordinary course FRB regulatory and reporting requirements as if it were a U.S. BHC (whether or not the IHC owns a U.S. bank).
The purposes of the IHC requirement articulated by the FRB were several-fold. Among other things, the IHC addressed the FRB’s concerns that in the environment following the financial crisis, it was no longer realistic to assume, as previous policies had done, that a parent foreign bank would (or could) support its U.S. operations in times of stress. The FRB also observed that the U.S. operations of FBOs “became increasingly concentrated, interconnected, and complex after the mid-1990s,” justifying a change in regulatory approach. The IHC requirement also was motivated by concerns about the capital adequacy of broker-dealer subsidiaries of foreign banks regulated by the Securities and Exchange Commission, some of which are large and play a significant role in U.S. markets. In addition, the IHC requirement would, in the FRB’s view, provide a uniform platform for the supervision and regulation of U.S. subsidiaries of foreign banks in a format that more closely resembled the structure of U.S. BHCs. The FRB also suggested that the IHC structure would facilitate an orderly cross-border resolution of an FBO (79 Fed. Reg. 17240 17264-17269 (Mar. 27, 2014) (final rule)).
Shift in Application of the National Treatment Principle
When viewed in historical context, the IHC requirement indicates a distinct shift in the FRB’s application of the national treatment principle. Discussion about national treatment featured prominently in the rulemaking process – in both industry objections and the FRB’s response. In the preamble to the final rule, the FRB stated that “the principles of national treatment and equality of competitive opportunity were central considerations in the design of the enhanced prudential standards for foreign banking organizations" (79 Fed. Reg. at 17268).
From the foreign banks’ perspective, the IHC requirement contravened national treatment because it did not treat foreign banks operating in the United States comparably to U.S. BHCs (e.g. did not apply or adapt EPS on a consolidated basis, and applied capital and other requirements on a sub-consolidated level). From the FRB’s perspective, the IHC requirement was consistent with national treatment because IHCs would be subject to a regulatory framework, including EPS, that was comparable to the framework that applies to U.S. BHCs. These perspectives in the end appeared to be two ships passing in the night, as the foreign banks and the FRB defined the relevant equation differently.
It is this difference – in how national treatment was applied in practice – that marked the most distinct shift from historical approaches. As traditionally articulated, and as phrased by Tarullo in his speech at Yale, national treatment is defined as comparable treatment for domestic and foreign institutions “in like circumstances.” For the FRB in designing the IHC requirement, the institutions in like circumstances were U.S. BHCs and IHCs. As long as the treatment between these two groups was comparable, national treatment was achieved. However, like virtually any non-discrimination question, the rub lies in how like circumstances are defined. For the foreign banks, IHCs could only be viewed as in like circumstances with U.S. BHCs if one were to first force an FBO’s U.S. subsidiaries into a BHC-like structure, akin to the roll-up requirements that had previously been rejected on national treatment grounds, and then ignore the fact that an IHC is a subgroup of a consolidated FBO, which itself is subject to consolidated capital, liquidity, and other prudential requirements.
The FRB’s articulation of the national treatment equation as based on the structure and regulation of the U.S. operations of a foreign bank in isolation, without regard to their ownership by, and role as part of, a foreign bank, is precisely the point at which the shift in application of national treatment occurred.
One can also illustrate this shift by applying the FRB’s “new” national treatment principle backwards through the historical context described above. For example, if the FRB’s current views of national treatment had been applied in the context of the IBA, Congress would not have given the OCC authority to waive director citizenship requirements for national banks owned by FBOs in the name of national treatment. A national bank owned by a U.S. BHC is – at the level of the national bank – no different than a national bank owned by an FBO. It is only because of the national bank’s ownership by, and role as part of, an FBO, that the need for such an adaption becomes appropriate. Similarly, Congress’ decision to measure a federal branch’s lending limit as a percentage of the foreign bank’s consolidated capital is an adaption that is based on an understanding of the federal branch’s role as part of a foreign bank; otherwise, in theory a federal branch’s loans would need to be limited to some measure of deemed capital of the branch itself based on the branch’s balance sheet. Lastly, when the Kentucky Bankers Association pressed to require foreign banks to operate through bank subsidiaries in order to branch across state lines, Congress (at the urging of the Treasury Secretary) instead concluded that in order to achieve national treatment foreign banks needed to be permitted to establish direct branches in multiple states without incorporating a U.S. bank subsidiary, even though – at the level of the U.S. bank subsidiary – that would have made the structure and regulatory framework the same and would have provided a consistent platform for interstate branching regulation.
The Broader Implications
The U.S. national treatment principle, which has both benefitted and burdened foreign banks operating in the United States since the 1970s, has important practical and policy implications for all internationally active banks. How the principle is defined and applied in practice by the FRB is critically important, not only for FBOs (because of the direct consequences for their U.S. operations), but also for all internationally active banks in view of the FRB’s leading role as an international bank supervisor and its role as the consolidated supervisor of many of the world’s largest banking organizations. National treatment historically has been a U.S. policy priority in part because it strengthens our government’s hand in trade negotiations where access to financial markets is at issue. And more broadly, U.S. national treatment for foreign banks helps promote U.S. banks seeking national treatment abroad.
This consequence becomes especially relevant as many jurisdictions, including ones with major financial centers, continue to consider their own structural approaches to the regulation of domestic and cross-border banking operations. And it leads to the question of how the FRB’s recent shift in application of the national treatment principle will inform other countries’ approaches.
Defining national treatment based on how U.S. regulations are applied to U.S. operations of foreign banks in isolation (without regard to their role as part of an FBO) arguably reflects the broader thrust of FRB policy developments in this area. A “Fortress America” approach involves a distinctly discounted reliance on parent bank and home country support and cross-border supervisory coordination, understandably reflecting the FRB’s experiences during the financial crisis and its outlook on how relevant actors are likely to behave in a future crisis. Thus, it may be that as other countries turn inward and adopt a more nationalist approach to banking and financial stability regulation, notwithstanding ongoing efforts to coordinate internationally, they will follow the FRB in redefining the application of national treatment, with potentially lasting changes to the organizational structure and efficiency of cross-border banking.