Close the Foreign Parallel Bank Loophole

On December 14, 2012, the Board of Governors of the Federal Reserve System released a Notice of Proposed Rulemaking for Enhanced Prudential Standards and Early Remediation Requirements for Foreign Banking Organizations and Foreign Nonbank Financial Companies.  At 306 pages, it outlines a revised architecture of enhanced prudential standards for Foreign Banking Organizations (FBOs).  Those standards include risk-based capital and leverage requirements, liquidity standards, risk management and risk committee requirements, single-counterparty credit limits, stress test requirements, and a debt-to-equity limit for companies that the Financial Stability Oversight Council has determined pose a grave threat to financial stability.

In addition to implementing Dodd-Frank statutory requirements, the enhanced prudential standards reflect several lessons-learned from the financial crisis:

“Actions by a home country to constrain a banking organization's ability to provide support to its foreign organizations, as well as the diminished likelihood that home country governments of large banking organizations would provide a backstop to their banks' foreign operations, have called into question one of the fundamental elements of the Board's current approach to supervising foreign banking organizations – the ability of the Board, as a host supervisor, to rely on a foreign banking organization to act as a source of strength to its U.S. operations when the foreign banking organization is under stress.

The issues described above-- growth over time in U.S. financial stability risks posed by foreign banking organizations individually and as a group, the need to minimize destabilizing pro-cyclical ring-fencing in a crisis, persistent impediments to effective cross-border resolution, and limitations on parent support-- together underscore the need for enhancements to foreign bank regulation in the United States.”

A handy CliffsNotes-like table, created by the Fed, summarizes the proposed new prudential requirements:

Table 1—Scope of Application for FBOs 

Global assets	U.S. assets	Summary of requirements that apply
> $10 billion and < $50 billion	n/a	• Have a U.S. risk committee.
		• Meet home country stress test requirements that are broadly consistent with U.S. requirements.
> $50 billion	< $50 billion	All of the above, plus:
		• Meet home country capital standards that are broadly consistent with Basel standards.
		• Single-counterparty credit limits28.
		• Subject to an annual liquidity stress test requirement.
		• Subject to DFA (Dodd-Frank Act) section 166 early remediation requirements.
		• Subject to U.S. intermediate holding company (IHC) requirements:.
		○ Required to form U.S. IHC if non-branch U.S. assets exceed $10 billion. All U.S. IHCs are subject to U.S BHC capital requirements.
		○ U.S. IHC with assets between $10 and $50 billion subject to DFA Stress Testing Rule (company-run stress test).
> $50 billion	> $50 billion	All of the above, plus:
		• U.S. IHC with assets >$50 billion subject to capital plan rule and all DFA stress test requirements (CCAR).
		• U.S. IHC and branch/agency network subject to monthly liquidity stress tests and in-country liquidity requirements.
		• Must have a U.S. risk committee and U.S. Chief Risk Officer.
		• Subject to nondiscretionary DFA section 166 early remediation req

What's missing from this proposed enhanced supervisory architecture for foreign banks is the opportunity to subject foreign parallel bank arrangements to supervision by the Board of Governors of the Federal Reserve System.

Foreign parallel banks are bank ownership structures where one or more banks in the United States are affiliated by common ownership, through natural persons or their instrumentalities, with banks in one or more foreign countries.  There are many of these ownership structures spread throughout the United States.  These foreign parallel bank ownership arrangements do not come under the present technical definition of a FBO.  But because of the close ownership ties, they can act like one.  These parallel bank structures can avoid Federal Reserve supervision altogether.

Let me give you one example, two of the largest private-sector banks in Venezuela, Mercantil Servicios Financieros CA (MSF) and Banesco Banco Universal CA (BBU), both have commercial bank affiliates headquartered in Coral Gables, Florida --- Mercantil Commercebank, N.A. and Banesco (USA).  Through intermediate holding companies, Mercantil Commercebank is directly owned by MSF and both MSF and Mercantil Commercebank are subject to full supervisory oversight as a FBO by the Federal Reserve Bank of Atlanta.

Banesco (USA), on the other hand, is beneficially owned by the owner of BBU in Venezuela, Juan Carlos Escotet.  Since there are no direct corporate connections between BBU and Banesco (USA), and since Banesco (USA) is a state non-member bank without a U.S. bank holding company, the Banesco-related entities, BBU and Banesco (USA), are not subject to Federal Reserve FBO oversight. 

So what? you may ask.  Well, it comes down to an issue of fairness and equal treatment for the two U.S. domiciled banks in this example.  In the arena of FBO supervision, home country bank supervisors are expected to have a robust program of comprehensive consolidated supervision (CCS).  The state of that home country supervision program feeds into the Fed's Strength of Support Assessment (SOSA) for each FBO.  If a country has not been conferred CCS status by the Federal Reserve, the Fed will typically disallow any entry of new foreign banks into the United States or constrain significant expansion of existing foreign bank presences in the U.S.  Venezuela does not have CCS status and it is not likely to receive such status in the intermediate future.

So Venezuela's present CCS status impacts bank supervisory deliberations on any significant expansion plans by Mercantil Commercebank, N.A.   Banesco (USA), on the other hand, can expand subject only to State of Florida and the FDIC approvals.  The Fed, its CCS criteria, and its SOSA process being totally out of the picture.  

Structures not subject to Federal Reserve supervision, through the use of foreign parallel banks, is a loophole in the foreign bank supervision fabric.  A loophole that could become more attractive as prudential standards for FBOs become stricter, such as those now being proposed in the Notice of Proposed Rulemaking.  The Foreign Bank Supervision Enhancement Act of 1991 was supposed to centralize the supervision and examination authority over foreign bank operations squarely with the Federal Reserve Board.  The indirect operations of foreign banks, through parallel bank arrangements, have effectively called that into question.

A foreign parallel bank arrangement may not technically look like a duck, dressed in drag like it is; but if it quacks like a duck, the Fed should call it a duck.