WASHINGTON — A Federal Reserve proposal to better regulate foreign banks in the U.S. would also significantly expand the central bank's oversight of foreign broker-dealers, effectively snatching supervisory responsibility from the Securities and Exchange Commission in the process.
The Fed's power grab was one of the most striking aspects of the December proposal, which already represented a large shift in how the central bank plans to supervise foreign banks, and suggested a lack of confidence in the SEC's existing oversight of broker-dealers.
"This rule is the Fed bringing the foreign bank broker-dealers into the Fed umbrella," said Margaret Tahyar, a partner with the law firm Davis Polk & Wardwell. "I think one regulator they are mistrustful of here is the SEC."
The Fed's plan is aimed at fixing the flaws in oversight of foreign institutions that were exposed by the financial crisis. (The central bank released a separate proposal in 2011 targeting U.S. bank holding companies.)
In the run-up to the crisis, foreign banks veered away from their traditional lending activities, moving toward more complex, capital market practices. Many began relying heavily on short-term wholesale U.S. dollar funding, which ultimately prompted destabilizing runs.
Some observers have said the SEC, which oversees all broker-dealers, may be at least partly to blame. Its net capital rule is seen as a driver of the crisis, allowing large investment banks like Bear Stearns, Goldman Sachs and Lehman Brothers to dramatically increase their leverage. The rule, which was revised in 2004 to allow certain haircuts, regulates the ability of broker-dealers to meet their financial obligations to customers and other creditors.
In the aftermath of the crisis, five of the largest U.S. broker-dealers are now owned by foreign banks. Similar to their U.S. counterparts, large foreign-owned U.S. broker-dealers had become "highly leveraged and highly dependent" on short-term funding in the years leading up to the crisis, according to comments made by Fed Gov. Daniel Tarullo at the Dec. 14 Board meeting releasing the central bank's plan.
It is a problem the Fed, particularly Tarullo, wants to correct. Of the 107 firms that will be affected by the new proposal, observers said roughly a dozen firms, which own the largest broker-dealers in the U.S., will feel the biggest impact of the new plan, including Deutsche Bank, Barclays Capital, and Credit Suisse.
"We would be negligent if we did not adapt our oversight of foreign banking operations that include these very large broker-dealers, as we have our domestic bank holding companies," Tarullo said at the meeting.
Observers said the move is clearly directed at the SEC.
"This is a bit of poke in the eye at the SEC," said a partner at a law firm, who requested anonymity, because of the sensitive nature of the matter. "In Tarullo's speech and in the preamble, one of the concerns they have is the leverage they perceive to have been built up in the broker-dealer affiliates, which were not subject to Fed capital regulation."
The Fed's proposal will allow supervisors to impose capital requirements on a broker-dealer through a U.S. intermediary holding company, while also giving it an early look at the entity in the event of a failure.
"This IHC superimposes capital regulation on the large broker-dealers, which is another way of the Fed saying it doesn't think the SEC's net capital rule is good enough," said the partner.
A spokeswoman for the SEC did not immediately respond to requests for comments.
What's striking to some is how the Fed crafted the proposal in such a way that an intermediary holding company is treated like a bank holding company regardless if it owns an actual bank. In addition to capital requirements, an IHC would also need to meet certain liquidity buffers and undertake stress testing exercises.
"The proposed rule would generally treat an IHC like a U.S. bank holding company irrespective of whether it owns a depository institution in the U.S," said Andrew Gladin, a partner at Sullivan & Cromwell's financial institutions and corporate and finance groups. "Thus, the foreign bank and its IHC would be subject to bank holding company capital requirements with respect to, for example, it's U.S. broker-dealer subsidiary and funding vehicle, even though it does not actually own a bank."
For regulators, the financial crisis revealed limitations on the ability of some foreign banks to act as a source of support to their U.S. operations under stressed conditions, raising the possibility that should foreign bank offices in the U.S. experience financial problems, they could have a hard time convincing their parent bank to obtain the financial support they may need.