Foreign banking organizations have long played a crucial role in U.S. capital markets. However, regulatory reforms implemented after the Global Financial Crisis appear to have contributed to a significant reduction in FBO participation. This post examines how the certain regulatory standards generally applicable to large foreign banks with U.S. operations have affected FBO activity in U.S. capital markets.
In particular, two key regulatory capital-related requirements (associated with ring-fencing and the maintenance of an additive capital cushion as a function of the Federal Reserve’s supervisory stress test results) have raised significant barriers for entry to the U.S. market for FBOs and their U.S. subsidiaries:
- The interplay between the intermediate holding company requirement and other post-crisis reforms has led to the segregation of bank capital by jurisdiction. The Federal Reserve’s supervisory practices have resulted in extremely high levels of capital being held in IHCs, in many cases without a clear indication of heightened or excessive risk. This situation has reduced the ability of FBOs to efficiently deploy capital globally, weakened market liquidity in times of stress and created a disincentive for FBOs to inject capital into their U.S. subsidiaries, because extracting capital from a legal entity has become time-consuming, costly and uncertain.
- The FRB’s stress capital buffer requirements disproportionately affect IHCs due to their greater reliance on non-interest income from trading activities. The current pre-provision net revenue modeling approach may underestimate trading revenues and inaccurately forecast expenses, resulting in higher capital requirements for IHCs compared to domestic banks.
The post will explore how these factors have led to declining FBO market share across fixed income, currencies, and commodities trading, equity trading, and investment banking. We’ll also discuss the potential consequences of reduced FBO participation on U.S. capital market efficiency and liquidity, particularly during periods of market stress.
These issues are expected to be further compounded when the U.S. Basel III Endgame operational risk framework is finalized, perhaps as early as 2025. This framework is anticipated to be particularly punitive to banks with fee-based businesses, which include many FBOs.[1] As IHCs derive a larger portion of their revenue from fee income-based businesses compared to U.S. banks, they are likely to face higher operational risk capital requirements under this new framework.
The post primarily focuses on capital issues and but does not address other intercompany frictions introduced by U.S. resolution plans, namely resolution liquidity and positioning and resolution liquidity execution need requirements, given its focus on capital issues.[2] However, it is important to note that resolution plans also include resolution capital adequacy and positioning (RCAP) requirements. In certain circumstances, RCAP could be a binding capital constraint for firms.
Empirical Analysis
FBOs play an important role in U.S. capital markets, with six out of the 12 major players being FBOs. However, regulatory reforms implemented in the aftermath of the GFC have likely been reducing FBO participation in those markets.
Before the GFC, banks were primarily regulated based on a consolidated view of their assets and liabilities. But the U.S. broker-dealer subsidiaries of FBOs were regulated by the U.S. Securities and Exchange Commission under its net capital rule, rather than by the FRB. After the GFC, the FRB noted that broker-dealer subsidiaries of FBOs might fall outside its supervisory purview if not structured as subsidiaries of a U.S. bank holding company.
In 2016, new reforms were introduced to address regulatory concerns about large U.S. broker-dealer subsidiaries of FBOs. These reforms required FBOs with over $50 billion in total consolidated U.S. assets to establish an IHC. Each IHC must now have its own board of directors and is subject to enhanced prudential standards like those applied to domestic BHCs of comparable size. These standards include requirements for capital, liquidity, capital stress testing, capital planning and long-term debt.
While these regulations have increased the levels of capital held by IHCs in the United States, they have also had unintended consequences. The consistent application of these standards to both IHCs and U.S. BHCs that have raised concerns among FBOs. In recent years, this regulatory approach has led to a significant reduction in the size of FBOs’ U.S. operations, potentially affecting market liquidity and diversity.[3],[4]
To investigate why FBOs reduced their activities in the U.S. capital markets, we use three data sources. First, we examine each company’s annual report to gather information on bank revenues. Although these reports offer revenue data by business segments, they do not further disaggregate this information by region. Next, we analyze FR Y-9C regulatory filings to obtain IHCs’ revenues in the U.S. market. For domestic banks, the reported revenues include those from regions outside the United States. However, for FBOs, the revenues represent only their U.S. operations, as the reports only include U.S.-domiciled subsidiaries for IHCs. Then we obtain the stress capital buffer from the FRB’s large bank capital requirements.
In Figure 1, we assess the global market share of U.S. banks versus FBOs by types of activities. Panels A, B and C present the market shares in fixed income, currencies and commodities trading, equity trading, and investment banking division, respectively. Figure 1 shows a clear trend of declining market shares for FBOs across all divisions. Panels A, B and C show the market share of U.S. banks (the violet lines) in FICC trading, equity trading and IBD increased by 10.1, 19.0 and 12.2 percentage points, respectively. In contrast, the market share of FBOs (the orange lines) in equity trading, FICC trading and IBD decreased correspondingly.
Source: Segment disclosures in company filings.
Note: FICC = Fixed Income, Currencies, and Commodities, ET = Equity Trading, and IBD = Investment Banking Division. Coalition Index Banks are BAC, C, JPM, GS, MS, WFC, DB, CS, UBS, HSBC, BARC, BNP, and SG.
The decline in FBO activities shown in Figure 1 may have been driven by their operations in the EU or Asia instead of the U.S. markets. As we mentioned, company reports present global revenues including regions outside the United States. However, several studies offer empirical evidence that the post-GFC regulations changed the behavior of FBOs and reduced their U.S. operations.[5]
Figure 2 shows IHC revenues from securities brokerage and investment banking, advisory, and underwriting activities. Revenues for each category declined between 2016 and 2023. For instance, revenues for securities brokerage decreased by $2.3 billion. In addition, investment banking, advisory, and underwriting activities declined by $1.1 billion.
Source: FR Y-9C reports.
The data in Figures 1 and 2 indicate that FBOs have reduced the size of their U.S. business operations. The decline in FBOs’ U.S. operations is primarily associated with the increased cost of regulatory compliance, from the trapping of capital at the jurisdiction level and the stress capital buffer framework. FBOs may further cut back their operations when the new standardized approach for operational risk capital requirements is introduced as part of the U.S. Basel III Endgame, since it is expected to further increase the capital requirements of IHCs.
First, post-GFC regulations have resulted in segregation of bank capital by jurisdiction. As we mentioned, FBOs were subject to capital, liquidity and funding regulations imposed by their home-country regulators on the consolidated view of assets and liabilities. FBOs could move capital seamlessly between jurisdictions and subsidiaries; there were no internal or external constraints on intra-company capital mobility. Without capital regulation at the jurisdiction level, banks can move capital easily. Balance sheets were unconstrained, so banks could redistribute capital based on economic conditions.
After 2016, FBOs were required to organize their U.S. activities under IHCs. This impaired the mobility of capital, because shifting funds between bank subsidiaries now requires the recommendation of the local management team; the approval of the local board; consideration of local stress tests; and, at times, approval from local regulators. Capital requirements could constrain the banks’ ability to move and segregate capital into distinct and separate pools. This is because some FBOs are required to hold more capital than necessary if their U.S. activities are considered part of the consolidated parent company.
In addition, the segregation of bank capital across regions makes it costly for banks to implement any unplanned capital action. A bank that wants to reallocate capital between subsidiaries must go through a complex process of extracting capital from one entity and/or the reverse process of injecting capital into another. Returning to the initial state would require repeating these difficult procedures, further complicating capital management across subsidiaries.[6]
Second, the IHCs are more constrained by the SCB requirements than domestic banks because they rely more on fee income (about 76 percent as shown in Figure 4 below). The FRB’s supervisory stress tests estimate trading revenues as part of the non-interest-income component of the pre-provision net revenue, which is the sum of a bank’s net interest income and noninterest income less expenses before adjusting for loan loss provisions. Although net interest income is an important source of revenue for most banks, the non-interest-income component constitutes most revenues for the IHCs that rely on market-making and underwriting activities.
Some industry experts have suggested that the inaccuracy of revenue estimates from the PPNR modeling approach increases compliance costs.[7] For instance, the current approach to model PPNR might underestimate trading revenues for two reasons. It may underestimate trading revenue, because it estimates trading revenue using the combined trading revenue and mark-to-market losses in its calculations. In addition, the trading revenue model may not estimate revenues accurately. It is heavily influenced by historical capital markets data that may no longer be relevant, given new regulatory requirements and changes to banks’ product offerings. The PPNR modeling approach to estimating non-interest expenses from trading activities also ignores the strong correlation between trading revenue and trading expenses, resulting in inaccurate estimates for trading expenses.
Figure 3 shows the stress capital buffers of U.S. banks versus FBOs for the 2020–2024 period. On average, the stress capital buffers of U.S. banks are 3.6 percent, whereas those of FBOs are 6.2 percent. In other words, the SCBs of FBOs are nearly twice as high as those of U.S. banks.
Source: FRB’s stress test disclosures.
Third, under the initial Basel III Endgame proposal, IHCs would likely be required to hold more capital than U.S. banks under the operational risk framework, which is more punitive to the banks that rely on fee-based businesses. This is because the operational risk framework disproportionally penalizes banks whose business models rely more on noninterest fee-based income (such as capital market activities, custodial services and credit cards) rather than interest income. The operational risk framework relies on the business indicator component, which includes three components, all with specific combinations of profit and loss items: the interest, leases and dividend component; the services component; and the financial component. Unlike the calculation of the business indicator component’s interest component and the financial component, the services component does not offset revenues with expenses. There is also no upward limit on the size of the service component, although there is a cap on the interest component.
Figure 4 shows the percentage of fee income revenue against total revenues for U.S. banks versus FBOs and their U.S. IHCs. It shows that FBOs’ IHCs are much more reliant on fee income than U.S. banks and FBOs at the consolidated company (global group) level. On average, 53 and 58 percent of revenues come from fee income-based businesses for U.S. banks and FBOs at the global group level, respectively, whereas 76 percent of revenues come from fee income-based businesses for the FBOs’ IHCs.
Source: Company filings, FR Y-9C reports.
To assess the impact of the operational risk capital requirements on capital ratios, we calculate the common equity tier 1 (CET1) capital ratios of U.S. banks and IHCs before and after incorporating risk-weighted assets (RWA) for operational risk.
Figure 5 shows the CET1 capital ratios of U.S. banks and IHCs. Before incorporating operational risk RWA, the aggregate capital ratio of U.S. banks stands at 13.3 percent, compared with 19.8 percent for IHCs. After adding operational risk RWA, these ratios decrease to 11.5 percent for U.S. banks and 16.1 percent for IHCs. This comparison shows that the decline in the CET1 ratios for IHCs is twice as large as that of U.S. banks.
Source: BPI, FR Y-9C reports.
Conclusion
After the GFC, FBOs with over $50 billion of total assets in financial subsidiaries in the U.S. were required to establish IHCs. This regulatory change, along with other post-crisis reforms, has led to significantly higher capital levels in IHCs, often without clear evidence of increased risk. In response, large FBOs have reduced their participation in the U.S. capital markets, while others have been deterred from expanding their U.S. operations. This trend is evident across fixed income, currencies, commodities trading, equity trading and investment banking.
U.S. regulators should conduct a holistic review of how these regulations interact, considering the unique nature of IHCs. The current regulatory environment has impaired the mobility of bank capital across subsidiaries and reduced the diversification benefits of global banks. This review should include adjustments to the Fed’s stress testing models to better reflect the business models of IHCs and to modify the proposed standardized approach for operational risk under the Basel III Endgame proposal to account for the unique risk profile of IHCs.
The ultimate aim should be to maintain financial stability while simultaneously preserving the benefits that FBOs bring to U.S. capital markets through their participation.
References
DiSalvo, James (2019, Q3). “Banking Trends: How Foreign Banks Changed after Dodd–Frank.” Federal Reserve Bank of Philadelphia Research Department. https://www.philadelphiafed.org/-/media/frbp/assets/economy/articles/economic-insights/2019/q3/bt-dodd-frank-foreign-banking.pdf
Humble, Mackenzie (2020, October 14). “The Treacherous Landscape for Foreign G-Sibs: The IHC Framework and Financial Stability.” Columbia Business Law Review, Volume 1, p. 336. https://journals.library.columbia.edu/index.php/CBLR/article/view/7161
Kreicher, Lawrence L., and Robert N. McCauley (2018, March). “The New U.S. Intermediate Holding Companies: Reducing or Shifting Assets?” BIS Quarterly Review, Box B, pp. 10–11. https://www.bis.org/publ/qtrpdf/r_qt1803u.htm
Meli, Jeffrey, and Zornitsa Todorova (2023, December 12). “Financial Segregation and the Changing Nature of Shocks: Evidence from the International Repo Market.” https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4662592.
Noonan, Laura (2019, November 24). “European Banks Slash $280bn from Main U.S. Businesses.” Financial Times. https://www.ft.com/content/ef651618-0b08-11ea-bb52-34c8d9dc6d84
Paligorova, Teodora, and Judit Temesvary (2021, May 12). “Foreign Banks’ Asset Reallocation in Response to the Introduction of the Intermediate Holding Company Rule of 2016.” FEDS Notes No. 2021-5-12. Board of Governors of the Federal Reserve System. https://doi.org/10.17016/2380-7172.2886.
Securities Industry and Financial Markets Association (SIFMA) (2020, December). “Federal Reserve’s Off Cycle Stress Test Is Most Severe Stress Test Ever, Punishes Capital Market Activity.” Pennsylvania + Wall Blog. https://www.sifma.org/news/blog/federal-reserves-off-cycle-stress-test-is-most-severe-stress-test-ever-punishes-capital-market-activity
[1] Humble, Mackenzie (2020, October 14). “The Treacherous Landscape for Foreign G-Sibs: The IHC Framework and Financial Stability.” Columbia Business Law Review, Volume 1, p. 336, https://journals.library.columbia.edu/index.php/CBLR/article/view/7161; Meli, Jeffrey, and Zornitsa Todorova (2023, December 20). “Financial Segregation and the Changing Nature of Shocks: Evidence from the International Repo Market.” https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4662592
[2] RLAP estimates the amount of liquidity material entities need to stay operational during a 30-day stress period and RLEN estimates the amount of liquidity material entities need to stabilize and operate after the parent fails.
[3] Noonan, Laura (2019, November 24). “European Banks Slash $280bn from Main U.S. Businesses.” Financial Times. https://www.ft.com/content/ef651618-0b08-11ea-bb52-34c8d9dc6d84
[4] Paligorova, Teodora, and Judit Temesvary (2021, May 12). “Foreign Banks’ Asset Reallocation in Response to the Introduction of the Intermediate Holding Company Rule of 2016.” FEDS Notes No. 2021-5-12. Board of Governors of the Federal Reserve System. https://doi.org/10.17016/2380-7172.2886
[5] DiSalvo, James (2019, Q3). “Banking Trends: How Foreign Banks Changed after Dodd–Frank.” Federal Reserve Bank of Philadelphia Research Department, https://www.philadelphiafed.org/-/media/frbp/assets/economy/articles/economic-insights/2019/q3/bt-dodd-frank-foreign-banking.pdf; Kreicher, Lawrence L., and Robert N. McCauley (2018, March). “The New US Intermediate Holding Companies: Reducing or Shifting Assets?” BIS Quarterly Review, Box B, pp. 10–11, https://www.bis.org/publ/qtrpdf/r_qt1803u.htm; Paligorova and Temesvary (2021).
[6] Meli and Todorova (2023).
[7] Securities Industry and Financial Markets Association (SIFMA) (2020, December). “Federal Reserve’s Off Cycle Stress Test Is Most Severe Stress Test Ever, Punishes Capital Market Activity.” Pennsylvania + Wall Blog. https://www.sifma.org/news/blog/federal-reserves-off-cycle-stress-test-is-most-severe-stress-test-ever-punishes-capital-market-activity
