Exporting U.S. Rules for Foreign Banks

One of the biggest loopholes on Wall Street may soon close.

More than three years ago, Congress passed a sweeping overhaul of the financial system that was supposed to leave no big bank untouched. Staggeringly, though, half of the large banks on Wall Street are able to avoid crucial parts of the overhaul â€" simply because they are foreign.

In particular, the overseas banks â€" Barclays, Deutsche Bank and Credit Suisse among them â€" have not had to comply with parts of the overhaul, known as the Dodd-Frank Act, that aim to strengthen the financial buffer, or capital, that banks must maintain to absorb potential losses on loans and trades.

Now, however, the American authorities appear poised to snatch that advantage away.

The Federal Reserve, which regulates banks, is expected to complete rules soon that will force large foreign banks to abide by many of the requirements their American counterparts have had to operate under since the passage of Dodd-Frank.

The foreign banks are not pleased with the crackdown.

The Fed first proposed the foreign bank rules at the end of 2012 and, as is its practice, invited the industry and the public to provide feedback. The Fed received strongly worded letters in opposition from a handful of large foreign lenders, and even got complaints from certain foreign bank regulators, including the BaFin of Germany.

In the face of such criticism, it is possible the Fed will end up substantially softening its rules. But senior executives at the foreign banks said they did not expect much in the way of dilution. “We, at this point, don’t expect any larger changes to it, maybe some clarifications,” Stefan Krause, Deutsche Bank’s chief financial officer, said on Monday in a conference call with analysts after reporting a $1.3 billion loss in the fourth quarter.

A final rule that looks largely like the original version may satisfy consumer advocates who contend that all large institutions operating in America should be subject to the country’s rules. “Whether the foreign banking rule gets done is a big test,” said Marcus Stanley, policy director at Americans for Financial Reform. And if the rules do have teeth, it will end an intriguing game of cat and mouse, in which some overseas banks have taken elaborate steps to escape the reach of regulators.

Congress wrote Dodd-Frank so that its rules on capital would apply to foreign lenders, which received substantial assistance from the Fed in the heat of the financial crisis. After the legislation went into effect, however, Barclays and Deutsche Bank changed the legal status of their big American operations in such a way that parts of Dodd-Frank did not apply to them. This effectively allowed them to avoid putting large amounts of capital into their American units to satisfy the law’s requirements.

Bank executives sometimes resist calls to raise extra capital because it may mean selling new shares, which can weaken the measures of profitability that Wall Street obsesses over. And if Dodd-Frank had applied, it might have forced some foreign firms to raise substantial amounts of new capital. The Deutsche Bank American operations containing its powerful Wall Street businesses actually had a negative capital position at the end of 2011, according to regulatory measurements of capital contained in a public filing.

Since the legal status of Barclays and Deutsche Bank changed, outsiders have no longer been able to get a clear picture from filings of the capital positions of their combined American operations. But Shailesh Raikundlia, a bank analyst with Espírito Santo Investment Bank in London, estimates that Deutsche Bank may need to find roughly $14 billion in capital for its American units. “Basically, Deutsche could raise some capital and downstream it,” he said. “This will have a negative impact on their profitability.” In recent conference calls, however, Mr. Krause of Deutsche Bank has played down the financial impact of the new rules and stressed that a transition would be manageable.

Even so, the European banks say the Fed’s rules are unfair. In particular, American banks are not required to lock up capital at their American operations, like the Europeans will have to. Instead, they contend, the Americans generally get to set capital for their firms as a whole, which gives them more freedom to move capital among their different operations. The Americans also do not have to set up a new holding company for their American units, which, in theory, means they can avoid the potentially costly restructurings that the Europeans will most likely have to bear.

Supporters of the foreign bank rules, however, respond that it will remove a huge competitive advantage that some European banks have enjoyed for many years. Under the rule, they will now have to hold capital at their American operations that is roughly equivalent to that of their American rivals. “All this does is create a level playing field for banks operating in the United States,” said Dennis M. Kelleher, president of Better Markets, a group that has pressed for stronger curbs on the banking industry.

Even under the new rules, the largest American banks may effectively have more capital than their European counterparts. That is because the biggest American institutions currently face new, separate regulations from the Fed that would force them to maintain higher companywide leverage ratios â€" a crucial measure of capital â€" than most foreign banks will have to.

One looming question is whether the Europeans will retaliate against the new rules once they go into effect â€" and force American banks to lock up capital at their operations overseas. But the Americans, with higher levels of capital, may be able to handle such a move.

Some consumer advocates say they would welcome a move by Europe to further toughen its banking regulations.

“Considering the number of problems with American banks that have occurred in London subsidiaries, I would appreciate seeing the Europeans raise the bar for foreign operations of American banks,” Mr. Stanley said. “That would be a win for the American taxpayer.”