Regional President Speech

THE FOREIGN BANK SUPERVISION ENHANCEMENT ACT OF 1991 Remarks by Robert P. Forrestal President and Chief Executive Officer Federal Reserve Bank of Atlanta To the XXV International Meeting, Banesto Estepona, Spain June 6, 1992 jBuenos dias! For 25 years now, bankers, central bankers, and finance ministers have been coming to this international meeting. Their attendance shows that they understand how important it is to think about the way in which the world behaves beyond one’s own borders. Certainly, too, participants at this meeting have always been concerned with the safety and soundness of the banking industry-not just in their own countries but also around the world. Banking rules and regulations are an important element of our increasingly linked financial markets. Without them, the likely interruptions in credit intermediation could harm people and damage businesses in many countries. Today, I would like to explain how a new U.S. international banking law should help to make banking safer and sounder throughout the world, not merely in the United States. My goal this morning is to explain the major provisions of the law, called the Foreign Bank Supervision Enhancement Act of 1991 (FBSEA). I will focus on its origins and significance because many of the technical details have yet to be made final. Background To explain how U.S. regulation of foreign-owned banks has changed, let me first summarize how foreign banks operated under the previous laws. At the end of 1991, there were Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 2 more than 300 foreign banks with operations in the United States. They had total assets of nearly $870 billion. Branches and agencies of foreign banks alone had aggregate assets of more than $700 billion. This amount accounted for 20 percent of total banking assets in the United States. As you know, the regulatory structure of U.S. banking is complex and confusing. For example, several agencies, some federal and some state, have regulatory authority. Supervision of foreign-owned banks has been no less complicated. Therefore, I will not attempt to give you a complete picture here. There are two points you should be aware of: Although foreign banks have the option of being licensed by the federal government or the individual states, the overwhelming majority have elected to be licensed by the states. As a result, state banking authorities have been the primary supervisors. From a statutory perspective, the Federal Reserve has exercised a residual authority over supervision. The state regulators gain information to monitor the behavior and performance of state-licensed foreign offices through call reports, country-risk exposure reports, and examinations. Basically, these foreign bank offices have been treated in the same way as state-chartered U.S. banks. The principal difference is that they did not uniformly undergo annual bank examinations.I I am happy to say that nearly all of these foreign bank offices have operated fairly and competitively. In addition, they have contributed materially to the U.S. economy. However, as I am sure you are aware, an allegedly illegal operation took place in my own city of Atlanta— Banca Nazionale del Lavoro. On a larger scale, Bank of Credit and Commerce International (BCCI) seems to have operated beyond the boundaries of safety and soundness. While there was little or no loss in the United States, the real tragedy of BCCI is the terrible effect its actions Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 3 had on developing countries. Customers in these countries could least afford to shoulder the losses they incurred. Why the Change was Made In one sense, the new law comes in response to BCCI and the problems it unveiled. That is to say, the excesses of BCCI were the proximate cause of the change. BCCI was able to conceal many of its maneuvers. That is because its chartering framework was designed to avoid significant regulatory oversight. The disparity in standards of supervision and regulation among countries made this feasible. BCCI could, in essence, shop around for a country in which to set up headquarters based on how lax its oversight was. The new law is aimed at preventing a replay of this scenario. Beyond the immediate reason for changing our international banking law, however, lies a larger impetus-excessive risk in the financial services industry. The problems the United States has encountered stemmed primarily from our deposit insurance subsidy. More specifically, the root cause is what we call the implicit safety net. What that means is that regulators may decide that the failure of a large bank would be such a shock to the banking system that they simply cannot allow it to fail. In practical terms, this "too big to fail" doctrine means that virtually all depositors and creditors in a large bank, not only those specifically covered by deposit insurance, will be reimbursed. This implicit safety net is reassuring to depositors and thus is also a strong deterrent to bank runs. However, it has caused excessive growth in the number of banks in the industry. Having too many banks has resulted in the kind Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 4 of competition that reduces the profit margins of banks. Too much competition also shrinks capital ratios and increases bank failures. In the late 1970s and early 1980s, there were some well-intentioned efforts to remove a number of restrictions on depository institutions. However, these efforts, combined with the deposit insurance subsidy, led to excessive risk-taking. For example, many banking and thrift executives took on an inordinate number of real estate loans that later became problem loans. Even more socially painful was our experience with the crisis in the savings and loan industry. The bail-out of the industry is now costing U.S. taxpayers billions of dollars. As a direct result of the savings and loan crisis and an increase in bank failures, Congress late last year passed legislation called the Federal Deposit Insurance Corporation Improvement Act. This act seeks to decrease excessive risk in the U.S. financial system. The law addresses insider lending, prompt closure of ailing banks, borrowing from the central bank, and much more. Congress was also concerned about the U.S. banking system being exposed to certain activities of foreign bank operations in the United States. The Foreign Bank Supervision Enhancement Act thus became part of the Federal Deposit Insurance Corporation Improvement Act. Through this act, Congress sought to strengthen the federal role in foreign bank regulation. It did so by requiring the approval of the Federal Reserve prior to the establishment of U.S. offices by foreign banks. The act also enhances the tools the Federal Reserve has to supervise foreign bank operations in the United States. I I will go over the specifics of this legislation as it pertains to foreign bank supervision Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 5 in a moment. At this point, though, I want to emphasize that protectionism was not a motive for the law. I am aware that some people argue that it was a thinly veiled attempt by the U.S. Congress to reduce foreign bank presence in the United States. However, U.S. policy has long sought to ensure that foreign and domestic banks have a fair and equal opportunity to participate in our markets. This policy was adopted in part because it is equitable and nondiscriminatory. Another more practical reason is that having international banks competing with domestic banks benefits U.S. consumers. A more varied and efficient banking market gives them the chance to choose the best services at the best prices. Although it is true that there is a troubling protectionist sentiment in the United States today, I believe this new law works very much to further free trade. In the main, it guards against the serious ramifications that a large bank failure could have for multinational companies and even individual countries. Specifics of the New Law Let me turn now to the main provisions of the new law. What follows will be a snapshot, in a sense, of how things stand. That is because more interpretation and final regulations are still to come. There are eight provisions: 1 (1) The first and, in certain respects, most important provision is that a foreign bank must obtain prior approval from the Board of Governors of the Federal Reserve System to establish an office in the United States. This significant change to greater federal oversight should ensure that uniform financial, managerial, and operational criteria for entry into the United States are applied. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 6 (2) One of the mandatory requirements is that a foreign bank be supervised on a consolidated basis by its home country authorities. The Federal Reserve staff will determine whether, in its judgment, the home country supervision is adequate. To do so, staff will assess whether the home country supervisor considers the full scope of operations of the bank or only those within the borders of the home country. Another standard for entry requires the foreign bank to agree to provide information on its operations and activities. This requirement was added so that the Board can determine whether the bank is complying with the new law and other federal laws. (3) One provision applies to those foreign banks that have already established offices in the United States. The law provides that these offices can be closed under certain circumstances: for example, if the bank is not subject to home country supervision on a consolidated basis, if it commits egregious violations of U.S. law, or if it engages in unsafe or unsound banking practices. (4) Another major provision calls for the Federal Reserve to examine regularly and frequently any office of a foreign bank or any commercial lending company controlled by a foreign bank in the United States. Specifically, the law requires an examination at least every 12 months. (5) The law also permits sharing of supervisory information with home country supervisors. This provision parallels the greater sharing of information among regulators that U.S. banking authorities have implemented in recent years. Before the Board discloses any information, it should receive assurances from the foreign supervisor that it will maintain the confidentiality of the information. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 7 (6) Two other provisions restrict certain activities of a foreign bank office. Like U.S. banks, foreign banks will now be limited with respect to the amount of loans they can make to one borrower. (7) In addition, there will be new restrictions on retail deposit-taking, although the final standard will be set later. (8) Finally, one provision applies to any foreign banking organization with a U.S. presence that acquires more than 5 percent of the voting shares of a U.S. bank or bank holding company. Such an organization must now obtain prior approval of the Board, just as U.S. bank holding companies must do under the Bank Holding Company Act. In summary, this new law should bar weakly capitalized, poorly managed, or inadequately supervised foreign banking organizations from entering the United States. It will also strengthen the capabilities of the Federal Reserve to uncover illicit and unsound activity of foreign-owned banks already operating in the United States except in extreme circumstances. Significance of the Law Now that I have outlined the Foreign Bank Supervision Enhancement Act, let me turn to its likely impact. One question on the minds of many bankers, business executives, and policymakers is whether the new law will inhibit foreign banking activity in the United States. I believe the Federal Reserve is unlikely to terminate operations of international banks that are already in the United States, except in extreme circumstances. Thus, practically speaking, the current operations of most international banks should not be affected. However, as I mentioned, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 8 the activities of a foreign bank office can be ended if the bank violates U.S. law or if it cannot give evidence of financial strength based on a review of its consolidated organization. The biggest immediate effect is likely to be felt by those who are applying for expansion or new powers in the United States. For banks from foreign countries that do not have consolidated supervision, the new law will indeed limit their entry into the U.S. market—at least temporarily. There are two situations that might concern the Board as it reviews operations of foreign banks in the United States. First, those banks whose supervisors are lax in obtaining information or are unwilling to disclose information to the Board may find it difficult to obtain federal approval for a U.S. office. The reason is that secrecy goes against the very heart of the new law. Second, those banks in high-inflation, soft-currency countries may face a challenge in providing evidence of the financial strength of the parent bank to the regulators. I know that this law has caused many international bankers to question why the United States should set rules and regulations that will have an impact on banks and regulatory systems in other countries. My answer has two parts. Let me say first that Congress had no grand design. The new law is essentially pragmatic in approach and domestic in scope. It simply decrees that if you want to do business in the United States, you must have consolidated supervision. This law, for example, would have prevented a BCCI from doing business in the United States in the first place.I I recognize that this new law may do more than protect the U.S. banking system from Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 9 unsafe banks. The effects of the new law will probably spill over into other countries that may then be influenced toward supervising their own banks on a consolidated basis. This result is an unavoidable side-effect. However, most people would agree that it is generally a good side- effect. As developing countries continue to make domestic policy reforms, clearly more of them are coming into the mainstream of world commerce. I am particularly excited about the progress made by Latin America countries. Enhancing bank supervision should logically become part of their overall policy reforms. Bringing more countries into the realm of safe and sound banking practices will make for a stronger worldwide financial services industry. In turn, a stronger industry will promote greater international trade. This observation brings me to the second part of my answer. The healthier the financial system of a country is, the healthier its economy. I believe the same could be said of the international economy.I I admit that the problems the United States has had in our own financial services industry have led us to be more concerned about banking practices throughout the world. What we have learned from this experience is that the implicit safety net of deposit insurance and its partner, the "too big to fail" doctrine, can lead to excessive risk-taking. Although other countries are not in exactly the same situation, many do have an unspoken "too big to fail" policy. That is to say, many countries have very few banks, each of which is so important to their local economies that it simply cannot be allowed to fail. Indeed, many are owned, at least in part, by the government. This situation carries intrinsic risk that can lead to serious problems. Consequently, I believe that to foster global economic integration, every nation must have strong supervisory and regulatory standards for its banks. Only such practices may prevent a "too big Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 10 to fail" crisis on the international level. Such a crisis would make the collapse of a BCCI seem almost insignificant. We as a family of nations must ensure collectively that a foreign bank is playing by the same rules as all other domestic and international banks. Only in this way can we decrease the chance that such a catastrophe may happen again. In that regard, this new law is another step toward implementing the standards to which all sound banks subscribe. While the new law comes in response to the problems revealed by the collapse of BCCI, in a larger sense, it represents a continuation of earlier moves toward international bank supervision. These moves began with the formation of the Basle Committee in Switzerland in the mid-1970s. This committee was formed in reaction to the failure of Herstatt Bank. We often think of Basle mainly as the source of international capital adequacy standards. However, the committee actually originally addressed itself to two propositions: that no foreign bank should be able to escape supervision and that supervision should be adequate throughout the world. Currently, many other countries besides the G-10 countries have adopted the Basle capital requirements. I expect there will be increasing pressure on banks from all countries to meet the internationally agreed-upon capital rules. This pressure to adhere to an international standard is similar to what we hope will happen with foreign bank supervision. If the new law can raise the standard in the United States, perhaps worldwide standards will also eventually be raised. An improvement like this would ensure a safer environment for all those who use banks. I I am mindful that there are those who reject, on principle, the idea that more regulation Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 11 is the best approach. These critics argue that we should be moving in the opposite direction, that is, toward more room for market incentives and discipline in financial services. There is some truth to this argument. More laws do, in fact, increase the regulatory burden on banks and, ultimately, business activity can be dampened at the margin by higher credit costs and less flexible financial services. In my own country, we have been trying for more than a decade to find ways to lessen this burden by deregulating the financial services industry. The goal is to enable the industry to be more flexible while becoming better capitalized and less dependent on subsidies. To be sure, we have not gone as far toward deregulation as some would like. There are those who advocate much more dramatic changes, like market valuation of bank loans. The allure of such pure market solutions is that they promise a clean break with the difficult problems of the past and a clean slate on which to begin the future. However, these solutions have been neither tested nor proved. They may also overlook the unintended and perverse side effects such abrupt changes are likely to cause. The challenge of the policymaker is to strike a reasonable middle ground between excessive regulation and the theoretical solutions of unfettered market dynamics. The Foreign Bank Supervision Enhancement Act—like its predecessor—the Basle accord—does that effectively, by combining elements of market discipline, as feasible, without moving headlong into the unknown. Conclusion In conclusion, the increasing global market for goods and services places greater pressure Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 12 on all of us. For one thing, we must ensure that our financial institutions are well equipped to serve as intermediaries in an ever more integrated global economy. U.S. legislators had one main purpose in passing this new law that promotes the safety and soundness of foreign banks in the United States. That is to reduce the possibility of excessive risks being taken by inadequately supervised banks operating in U.S. markets. I believe that this goal is no different from what all bankers and central bankers here would wish for their own nations and for the world. I hope you will now look at the new U.S. law in the way it was intended—as a continuation of a move begun almost two decades ago toward an enhanced international standard of supervision and regulation. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Robert P. Forrestal (1992, June 5). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19920606_robert_p_forrestal

@misc{wtfs_regional_speeche_19920606_robert_p_forrestal,
  author = {Robert P. Forrestal},
  title = {Regional President Speech},
  year = {1992},
  month = {Jun},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19920606_robert_p_forrestal},
  note = {Retrieved via When the Fed Speaks corpus}
}