International Finance

1. International Finance Week 8, Class 1 Banking Professor Diamond

2. International Aspects of U.S.Banking Regulation • The Operations and Importance of Foreign Banks • Systemic Risk and Foreign Banks • Safety and Soundness of Foreign Banks • Activities of Foreign Banks • New statutory environment in the US • Passage of Gramm-Leach-Bliley in 1999 (“GLB”) reforms banking in a fundamental way; reversing New Deal era reform (as we have seen with PUHCA and securities laws)

3. How Important are Foreign Banks in the U.S.?

4. Basics of U.S. regulation • Safety/Soundness • Deposit Insurance • Dual Banking Regulation • Activities Regulation • Interstate Banking • Community Reinvestment

5. U.S. Regulation: Safety/Soundness • Safety/Soundness - Goals: • Control Risk • Capital Adequacy • Aim is to prevent bank failure • No failure, then no pay out of deposit insurance • No failure of bank, less chance of systemic risk • A bank failure may start a chain reaction of bank failures (systemic risk) that undermines the banking system, through links in: • Inter-bank deposits (if failed bank holds deposits of healthy banks) • Payment system • Imitative runs - panic

6. U.S. regulations: Deposit Insurance • Deposit Insurance • Capped at $100,000 (per depositor per bank) • Checking, savings, CD’s not securities • New inflation linked ceiling in 2010 • Banks pay premiums into federal fund - rates linked to capital adequacy and a rating system • Thought to minimize the risk of bank runs

7. U.S. Regulations: Deposit Insurance • But creates a “moral hazard” • Creditors (depositors) may feel overconfident about potential risks and not police management • Management may take greater risk • Compare to shareowners • Principal agent problem again • Governance regime? • Need for special regulations as substitute?

8. U.S. regulations: Dual banking • Dual banking • Federalist concerns drive dual state and federal level regulation • Populist concern over concentration of economic power as in PUHCA • At federal level, Office of the Comptroller of the Currency (OCC) (Treasury); Federal Reserve Bank; and FDIC • State banking agencies regulate intrastate banks with Federal oversight • With sole national charter can now preempt state regulations and thumb nose at Elliott Spitzer

9. U.S. regulations: “Activities” • “Activities” regulation • Today, large banks typically operate as a subsidiary of a Bank Holding Company (“BHC”) • Public shareholders own the BHC, but not the bank itself (except indirectly) • BHC’s are allowed to engage in some activities that banks can’t if “closely related to banking” (BHC Act)

10. U.S. regulations: “Activities” • Pre-GLB, with Glass Steagall restrictions in place: • No life insurance • No commercial activities • Limits on securities activities • Prevents risk to subsidiary bank • BHC are supposed to be a “source of support” for the Bank - ready to put in more capital • Parallel limits: insurance, securities firms could not enter banking • So pre-GLB, no JPMorganChase

11. Activities Reform: GLB allows FHCs to Engage in Activities which are Financial in Nature Why allow activities in non-bank sub rather than bank sub? • Can do securities-dealing and underwriting • Can do insurance • Can do merchant banking FHC Non-Bank Subsidiary Bank • Some securities business • No insurance underwriting • No merchant banking Bank Sub

12. U.S. Regulations: Interstate • Limited Interstate Banking • But evolving: Out of state bank can buy “in state” bank without target state approval • But state antitrust and community reinvestment laws may apply • Federal concentration caps: <10% of U.S. deposits; or <30% of state deposits • BoA hit 9.7% in late 2005!

13. U.S. regulations: Interstate • Evolving interstate banking • Branches possible through merger, unless state “opts-out” • De novo expansion if state “opts-in” • Few have actually opted out and more than a dozen have opted in so interstate activity on the rise • BoA now in New York • Concentration ratios still apply here

14. U.S. regulation: CRA • Community Reinvestment Act (1977) • Feds encourage banks to meet credit needs of local communities - defined as area contiguous to local bank offices • Can be used to block bank expansion when seeking approval of regulators

15. Regulating FB’s in the US • Systemic Risk • Safety and Soundness • Deposit Insurance • Activities

16. Systemic Risk • Sometimes systemic risk is used to refer to bank failures not caused by a chain reaction • a failure of many banks in different countries caused by the same external shock, e,g, rapid rise in global interest rates • A failure of many banks through an economic spillover, e.g. Japanese low GDP has negative impact on non-Japanese economies causing bank failures

17. Systemic Risk • Large scale bank failures can be a major concern. Failures can cause deposit insurance payouts, uninsured depositor losses, and disrupt the economy • Deposit insurance payouts may involve public funds if bank insurance premiums are insufficient (U.S. 1980’s S&L crisis; Japanese NPL’s in “lost decade”, 1994-2004) • The concern with systemic risk leads to regulation to prevent bank failures

18. Systemic Risk • Classic example of systemic risk: failure of Long Term Capital Management (LTCM) • heavily leveraged hedge fund • borrowed billions from commercial and investment banks • It bet heavily against the dollar • The dollar went the other way and LTCM lost heavily - as much as 500 million in a single day in Sep. 1998 • Total loss: $4.6 billion • Federal Reserve and Treasury concerned that lenders would fail • Organized bail out process through New York Fed

19. Systemic Risk • How significant a risk is “systemic risk”? • Should it be an overarching concern of regulators? • How much of a risk to foreign banks pose? • Branch (home country) v. Subsidiary (host country) • Branches greater risk

20. Estimating Systemic Risk • Bartram, Brown, Hund (2004) look at the importance of the chain reaction effect by comparing the impact of an external shock on exposed and unexposed banks. • They find little increase in probability of default for non-exposed banks, e.g. 4% in Russian crisis • Hartmann, Straetmans and de Vries (2005): extreme risk increasing over time and higher in the U.S. than Europe, based on impact of bank failure(s) on stock prices, • e.g. Deutsche Bank would have a 55.4% chance of a major loss of stock value (.02%-.05% on negative distribution) from the failure of the 4 next largest German banks • Lehar (2005), no systemic risk in U.S. from FDIC portfolio (here mean threat to fund)

21. Systemic Risk and Foreign Banks Should the host (the Fed) or home central bank serve as “lender of last resort” for a foreign bank’s branch or sub in the U.S.?

22. Safety and Soundness of Foreign Banks • Safety and soundness regulation prevents or limits the effect of bank failure • Ex ante: examination, capital requirements, activity restrictions (e.g., limitations on loans to single borrowers, or commercial activities) • Ex post: Dealing with failed banks (e.g. deposit insurance, resolution procedures, bailouts) • Adequacy of foreign safety and soundness regulation of foreign banks operating in the U.S. through branches is a major concern of U.S. since foreign banks are primarily regulated by their home countries

23. Safety & Soundness: BCCI • Abu Dhabi funded bank in 1970s • Engaged in money laundering, terrorist finance, arms trafficking - clients included OBL and Abu Nidal • Some suggestion of CIA involvement to funnel money to mujahadeen fighters (anti-communists) • BoA was originally an investor • More than $13 billion unaccounted for • Closed down by Brits in 1991 • F. Lee Bailey a director of US sub in Florida • Clark Clifford involved; GWB got a loan from sub. • John Kerry made his bones in investigation

24. SUBSIDIARIES SUBSIDIARIES Safety & Soundness: BCCI Lessons (1991) BCCI STRUCTURE ABU DHABI & ITS RULING FAMILY HOLDING COMPANY, LUXEMBOURG BCCI, S.A. LUXEMBOURG BANK BCCI (OVERSEAS) LTD CAYMAN IS. BANK BRANCHES BRANCHES AGENCIES AGENCIES IN 69 COUNTRIES U.S. presence: no branches

25. Cayman Islands

26. $ Safety and Soundness:The Need for a Consolidation Caymans Bank Luxembourg Bank Examiners $ Caymans Bank Luxembourg Bank Examiners Worthless loan hidden

27. Overview Not Enough “We won’t collect” Luxembourg Bank New $100 MM Loan $100 MM Loan No Repayment $100MM Deadbeat Construction Borrower Mr. Assistor

28. The Lessons of BCCI? • Concern with solvency of foreign bank • Need for foreign bank entry/exit controls (branches particularly—U.S. adopts after BCCI) • Need for “effective” foreign supervisors (Luxembourg had no examiners—U.S. requires after BCCI) • Need for lender of last resort (Abu Dhabi—no formal requirement) • Need consolidated supervisor for overview (U.S. adopts after BCCI)

29. Consolidated Supervision Problems • Who is the overall regulator (choice of country)? • Holding company incorporation (e.g. Luxembourg) • Major business (U.K.) • College approach (who is the head?) • Role of home versus host country (Basel Concordat); home country cannot easily inspect branches • Secrecy: How does consolidated supervisor get information on operations in Nassau?

30. Supervision Problems • Why does we care about safety and soundness of foreign banks if branches of these banks cannot in US at least now take insured deposits (response in 1991 to BCCI)? • Should they be able to do so?

31. International supervision • The Bank for International Settlements (BIS) • Basel, Switzerland • Goal: to “foster cooperation among central banks and other agencies in pursuit of monetary and financial stability” • Set up in 1930 to manage WWI reparations payments • A bank for central bankers - manages forex reserves • A forum for policy and regulatory initiatives • Houses Basel Committee on Banking Supervision

32. International Rules in Banking • Basel Concordats (BIS Supervisors Committee): General Allocation of Authority Between Home and Host Countries for Subsidiaries and Branches of Foreign Banks • International Financial Architecture Initiatives • Basel Committee Rules on Bank Capital • 1997 General Agreement on Trade in Services (GATS) • Key Purpose: remove barriers to entry for foreign financial institutions • Key Principle: most-favored nation (MFN) • Has achieved limited results