The New Autarky?
How U.S. and UK Domestic and Foreign Banking Proposals Threaten Global Growth
By and Arthur S. Long
November 21, 2013
Since the 2007–08 financial crisis, global regulators have engaged in a lengthy struggle to reshape the international financial system to make it more resilient under stress. The purpose of this paper is to evaluate two recent and transformative proposals: the "Foreign Banking Organization" proposal of the U.S. Board of Governors of the Federal Reserve System and the United Kingdom’s "ring-fencing" plan. Both of these proposals are intended to protect national financial systems from the risks posed by a failure of one or more global, interconnected banking organizations operating within national borders.
We analyze whether the proposals are likely to meet their own stated objectives and consider their likely effect on the global financial system. We argue that these measures amount to little more than a mandatory, inefficient shuffling of corporate entities and business units that will not help ward off future financial crises. At the macro level, both proposals interfere with the ability of global banks to allocate capital and liquidity in the manner they determine to be most efficient. We find that the proposals, therefore, threaten to increase financial instability and dampen economic growth and signal an unfortunate step in the wrong direction.
These proposals underscore the problems with national regulators adopting a parochial, protectionist, or "home country first" approach to regulation. We argue that even poorer outcomes would have resulted from the prior crisis had these proposals been in place at the time. We contend that regulators should instead focus their attention on creating a credible, coordinated resolution process for globally significant firms.
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Introduction
The five or six years since the outbreak of the financial crisis have seen signs of a reversal of some aspects of the greater openness we had seen in the 1980s and 1990s. And probably none more so than the decline in cross-border bank lending . . . . International wholesale banking is . . . an important part of maintaining and developing the world economy, just as it was in the 19th century. Yet, we have to recognize that . . . [since] the crisis we have gone backwards.
So lamented Andrew Bailey, the deputy governor of the United Kingdom’s new Prudential Regulatory Authority, in a recent speech to the British Bankers Association.
1 And he is not alone in his concerns.2 Since 2008, commentators, industry professionals, regulators, and elected officials have made numerous, often contradictory, suggestions about how to deal with, or avoid, large bank failures. These suggestions range from "bailing in" creditors (explained below), to making banks smaller (whether through size caps or limitations on acquisitions), to limiting the activities that banks undertake (the "Volcker Rule" and similar initiatives), to imposing increasingly stringent regulations on larger organizations. Increasingly, however, regulators across the globe are looking inward, trying to insulate their domestic banking sectors from external shocks.3
This policy report does not purport to assess the costs and benefits of the multitude of rules and regulations that have been imposed on global banks in the wake of the 2008 financial crisis. Rather, we have chosen to focus on two specific proposals that we believe are indicative of the general trend described above. Both of the proposals discussed in this paper—the United States’ "Foreign Banking Organization" (FBO) proposal and the United Kingdom’s "ring-fencing" plan—are intended to protect national financial systems from the risks posed by a failure of one or more global, interconnected banking organizations operating within national borders. Because neither proposal has yet been implemented, it is difficult to measure the attendant costs, so we have instead focused on the
likely outcomes and whether each proposal can reasonably be expected to meet its stated aims as well as some of the potential downfalls that are suggested by parallel examples from history.
The FBO proposal is the Federal Reserve’s suggested implementation of Sections 165 and 166 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 for foreign banks.
4 Sections 165 and 166 require the Federal Reserve to impose enhanced prudential standards and early remediation requirements on "systemically significant" firms.5 The FBO proposal would cover foreign banking organizations that either operate a branch or agency office in the United States or own a U.S. bank or "commercial lending company" subsidiary.
The UK’s ring-fencing plan grew out of the recommendations of its Independent Commission of Banking,
6 which was constituted in the wake of the effective nationalization of the Royal Bank of Scotland Group (RBS) and Lloyds Banking Group.7 Under the proposal, UK banks would handle traditional retail banking activities such as deposits and overdrafts in separate subsidiaries. Those subsidiaries would be ring-fenced from the investment banking divisions and would have their own independent corporate boards and be required to meet higher capital requirements.
Both the U.S. and UK proposals evince a common theme: the belief that the current structures of large banking groups are themselves a threat to financial stability, and those structures are required to be fundamentally altered to enhance financial stability.
8
The Federal Reserve’s FBO proposal represents a seismic shift in the regulation of ...
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