Differences in the content and timing of rules on resolution planning, structural reforms and derivatives threaten to unravel cross-border banking models.

In its first consultation on total loss-absorbing capacity (TLAC) to ease the resolution of the world’s largest cross-border banks, the Financial Stability Board (FSB) included the concept of pre-positioning. This means 75% to 90% of the resources needed to recapitalise the local subsidiaries of a global parent – known as material subsidiaries of the resolution entity – would be held in the local jurisdictions. Speaking at the Financial Times/Banker banking summit in November 2014, Credit Suisse investment banking co-head Gael de Boissard depicted this as a significant departure from the previous efforts, especially in the Basel Committee on Banking Supervision, to develop genuinely global standards.

“TLAC is the first time under the [capital] framework that we have a fundamentally national concept. That’s new, and in a way we have accepted the reality that we have seen through the development of the resolution and recovery planning process of a fundamentally domestic-based thinking,” said Mr de Boissard.

Alongside TLAC and resolution planning, a number of key jurisdictions such as the US, UK and EU have implemented or are considering bank structural reforms that prohibit deposit-taking institutions from engaging in proprietary trading or impose ring-fences within universal banks to enable easy separation of retail banking and trading desks in the event of resolution.

“Banks are trying to retain the advantages of being global, but they also have to make statements about how they would implement structural reforms, such as the Bank of England’s requirement to see ring-fence plans by January 2015. It is questionable whether structural reforms are necessary if we have resolvability through TLAC and other initiatives, but regulators have a deep-seated belief – rightly or wrongly – that trading is inherently riskier than lending activities,” says Thomas Huertas, partner and coordinator of EY’s global regulatory network.

National subsidiaries


Asian approaches

Asian regulators have moved more gradually than the US or Europe to implement derivative rules and resolution planning, in part reflecting the lower degree of financial complexity in the region. But this does not mean they will necessarily follow a similar path to the US or Europe, or develop any form of regional consistency.

Although they have not declared it openly, it seems likely that the largest Asian financial centres – Hong Kong and Singapore – would like to see themselves as potential trading hubs. At present, derivatives trading poses a much smaller systemic risk in Asian markets than in the US and EU before the financial crisis. That means there is limited need for a heavy blanket of regulation, says Rebecca Terner Lentchner, head of policy and regulatory affairs at the Asia Securities Industry & Financial Markets Association.

“What is most useful is to build risk-worthy infrastructure, especially central clearing counter parties [CCPs]. There is a consensus among both buy-side and sell-side that Asian CCPs are rather opaque at present. That is not so important yet because they are currently small collectors of systemic risk, but as they evolve they will need to adopt best-in-class standards of resilience,” she says.

Keith Pogson, senior partner for Asia-Pacific financial services at EY, says Singapore and Hong Kong have retained a pragmatic line on whether wholesale banking operations in their jurisdictions need to be subsidiarised. This means global banks have more flexibility on the distribution of capital in these two markets, whereas others such as India, South Korea and Indonesia are more likely to push for ring-fenced capital in the local market. Even in Hong Kong and Singapore, however, foreign bank branches are still likely to face requirements to implement asset maintenance ratios that would trap liquidity in those branches.

“We have seen perhaps six or seven major derivative houses exploring whether it is possible or makes sense to create a single Asian booking location in a stand-alone ex-US subsidiary for uncleared over-the-counter derivatives trading such as foreign exchange swaps. Dealers have to examine how much capital they would need in a given jurisdiction and balance that with the need for a reputable regime that makes people comfortable with a transaction. Those banks that already have a network of subsidiaries on the ground are more likely to look instead at a multiple location customer-centric model,” says Mr Pogson.

For Asian banks that are becoming cross-border regional players, the scale involved is smaller. The Association of South-east Asian Nations (Asean) has a blueprint to form an Asean Economic Community in 2015. This includes the concept of Qualifying Asean Banks, and potential members have pledged to adopt Basel-compliant regulatory regimes by 2018 with a view to regional bank passporting by 2020. For now, however, regulatory co-operation has focused on bilateral memoranda of understanding rather than full mutual recognition regimes.

“We are seeing discussions that enabled Malaysian banks to operate in Indonesia, deals for funds passporting, and now the Hong Kong/Shanghai Stock Connect initiative. It is an exciting time, Asian regulators are trying to build closer links and to learn from the roll-out of cross-border rules elsewhere,” says Ms Terner Lentchner.

The FSB’s intention is that the TLAC proposals should improve the co-operation between jurisdictions, because it will give everyone more visibility about how a cross-border bank would be resolved. But Koos Timmermans, vice-chairman of the board at ING Bank, is concerned that the top end of the FSB’s proposed range for pre-positioning of internal TLAC (90%) may be going too far. He fears it could create incentives for host supervisors to bail in subsidiaries early, knowing they have almost enough resources locally to recapitalise the subsidiary completely.

That incentive would be even stronger if banks were able to move pre-positioned TLAC to other, more damaged subsidiaries. Moreover, the FSB proposal would leave supervisors with the discretion to add further TLAC requirements under the Basel pillar two (supervisory oversight) process.

“The pre-positioning of TLAC could lay the groundwork for home-host coordination as long as the FSB’s proposed balance is maintained. But if host countries start to demand that the subsidiaries they regulate hold larger amounts of capital downstream, the overall pattern does not work, because the sum of what banks would have to keep in the subsidiaries would exhaust the ability of the parent to hold a sensible amount of capital,” says Mr Huertas.

Breaking the branch

Mr Timmermans’ other concern is that pre-positioning of TLAC in material subsidiaries is likely to encourage host supervisors to require the creation of a subsidiary where a branch previously existed. The process of resolution planning has started this trend already.

“Most banks are evaluating how to migrate to a global subsidiarised model and how fast and far that needs to go. Very few have an expectation that they will be able to continue operating on an integrated cross-border basis – governance, capital, liquidity and the resolution planning requirements all drive toward an appreciation that firms in resolution are addressed on a jurisdiction-by-jurisdiction basis. The comfort level in most jurisdictions for relying on co-operation with other countries is fairly low,” says Marc Saidenberg, a principal at EY and former director of supervisory policy at the New York Federal Reserve.

The US has required foreign banking operations (FBOs) to collect their American subsidiaries into an intermediate holding company (IHC) that will carry its own capital and liquidity requirements, and could be bailed in separately. That challenge could be further intensified by the US stress-testing process. Mr Saidenberg believes for some foreign banks the effective capital that Fed stress tests will require in the US will exceed what would be required by their home supervisors, although the use of stress tests is rapidly spreading around the world.

“The new environment is leaning toward a change in funding model for some firms. Pre-crisis, many were comfortable sourcing dollar liquidity in the US to finance dollar assets globally, with little or no capital or liquidity attracted to those activities in the US. For groups that face solo capital requirements or scrutiny of trapped capital in their home jurisdiction, this is going to challenge their model,” says Mr Saidenberg.

Where to trade?

Most banks are already operating international retail banking services as a collection of subsidiaries, so the pressure to subsidiarise is mainly a concern for the economics of wholesale banking, says Mr Huertas. If wholesale banks cannot operate an overseas branch structure to reach their clients, they will naturally want to see if the clients can reach them via an international financial centre, such as London in the case of Europe.

“If the clients can come to the financial centre, that makes things manageable. But whether this works for every wholesale product is something that is in the process of being determined. We are working with some institutions to try to solve this problem, and the solution generally depends on how their home country regulation is going to change,” says Mr Huertas.

The focus on how to resolve global systemically important banks is also running parallel to difficulties between US and EU regulators in their efforts to provide equivalence regimes for post-crisis derivatives rules. Derivatives are global products, and the industry is certainly keen to avoid duplicate but differing regulation in the two largest financial market jurisdictions.

No-action relief

In November 2014, the US Commodity Futures Trading Commission (CFTC) extended its no-action relief for non-US swap dealers to comply with certain Dodd-Frank rules on trading via US-regulated swap execution facilities (SEFs) if they used any US personnel to handle a trade – even if the client is also a non-US entity. This still leaves the final rules unknown, but one US derivatives lawyer says the extension will be very welcome, as the deadline was already too close for banks to be able to comply.

“The extra-territorial guidance in 2013 was already contentious, and the CFTC’s interpretation of it came as a major shock. Many non-US banks use New York as a centralised location for handling Canadian and Latin American trading operations – all that business would have had to move out of the US in 2015,” says the lawyer.

New CFTC chairman Timothy Massad is becoming more closely involved in the agency’s guidance on extra-territorial issues. As well as the treatment of foreign banks, the impact of SEF rules on US bank operations overseas are also in play.

“Non-guaranteed affiliates of US banks are treated as non-US entities, but the CFTC’s definition of guarantees could potentially be broad enough to swallow up many types of relationship,” says the lawyer.


Taxing times

Bank regulation is not the only area stimulating concerns about a lack of cross-border coordination. Governments are also worried about the implications of poorly coordinated tax systems. The Organisation for Economic Co-operation and Development (OECD) launched an action plan to combat tax base erosion and profit shifting (BEPS) in July 2013, and has since been drafting consultation papers on the implementation of its 15 proposed actions.

The meeting of ministers from the G20 countries at Brisbane in November 2014 welcomed progress on the BEPS initiative and committed to “finalising this work in 2015, including transparency of taxpayer-specific rulings found to constitute harmful tax practices”. The G20 members also want a common reporting standard for the reciprocal automatic exchange of tax information by 2018.

“We are moving fast to limit the period of uncertainty. The rules are changing, and if they do not change at the OECD level, countries will change them in their own jurisdictions. The new rules will be known by the end of 2015, and a good investor will anticipate the environment, because the direction is clear,” says Pascal Saint-Amans, director of the OECD’s centre for tax policy and administration.

What matters to the financial sector is some degree of alignment between the direction of travel on tax and the many initiatives in the regulatory sphere. But that has not happened so far, according to EY international tax partner Anna Anthony.

"The OECD process is running separately, and is not necessarily focused on some of the specific characteristics of the financial services sector,” says Ms Anthony.

Areas likely to be affected include the effects of new VAT and transfer pricing rules on cross-border banks that hold their core functions in one entity that provides services internationally across the group. Banks will also need to understand the interaction between specific financial contracts and tax rules on whether an entity has a permanent establishment in a given jurisdiction.

“Some of these issues may not necessarily have large direct consequences in terms of an increased tax take, but they will impose huge additional costs of compliance in working out all the activities carried out by the bank’s staff, and where those activities are taking place. Approaches to reporting vary, and some banks currently report by business line rather than by country, which is what will be required by the OECD proposals,” says Ms Anthony.

Moreover, the SEF rules are just one part of the US extra-territorial equation. The Volcker Rule’s prohibition of proprietary trading has generated significant confusion among foreign banks. The rule is due to come into force in July 2015. US banks are allowed to make markets in US treasuries without falling foul of the proprietary trading ban, but the treatment of foreign banks and sovereign bonds is prompting serious concerns.

“Depending on which part of the rule you examine, it is unclear if a foreign banking organisation with a US subsidiary can trade its home sovereign debt anywhere or only in the US, which would be a very strange situation. There also seems to be an implication that local sovereign debt can only be traded in the home jurisdiction, which would raise questions about, for instance, trading German bunds in London,” says Derek Bush, a financial institutions regulatory partner at Cleary Gottlieb in Washington, DC.


The UK structural reform set out in the 2013 Banking Reform Act, including a ring-fence around core retail banking and essential operations, is due to come into force in 2018, so there is more time to iron out any ambiguities. Concentration limits will apply to the ring-fenced bank, so that its ability to finance its non-ring-fenced units will be constrained.

Possible EU structural reforms, along the lines set out in a report by Finnish central bank governor Erkki Liikanen’s expert group in 2012, are at an earlier stage of development. The European Council and European Parliament are still debating whether to adopt the Liikanen Report’s proposed separation of trading desk operations.

“Ring-fencing any part of a bank and requiring it to be separately funded and capitalised is a complicated requirement to meet, which unbundles long-established treasury mechanisms internally, so that each new function has to manage itself,” says Glenn Leighton, a managing director of balance sheet solutions in the financial institutions group at Barclays investment bank.

The UK approach, however, seems easier to implement because of the location of the proposed ring-fence. Inside the fence, the bank's retail and small business franchise will provide deposit funding. Outside the fence, larger corporate and international clients will have deposits that can fund the entity, potentially together with individual savings over the deposit guarantee cap. In Liikanen, by contrast, the trading book is potentially supposed to be ring-fenced as a specific entity.

“The trading book is not an entity, it does not have its own separate systems or people, it is just items within a portfolio that are not separately distinguished. The trading book has no natural customer base in the sense of customers coming into branches or retail funding. Individual derivative positions could be the aggregate of several customer trades or the positions of internal market risk managers,” says Mr Leighton.

From an international perspective, the operations of UK-headquartered banks that are outside the European Economic Area will need to be placed outside the ring-fence. Mr Huertas says this has sent a signal in itself to other jurisdictions, influencing the introduction of the US FBO rules and the domestic 'lifeboat' rule for Swiss banks that would separate their international operations in a resolution.

“That is also consistent with the legislation of many countries that sets the supervisor’s objective as promoting financial stability in the domestic jurisdiction, rather than internationally,” says Mr Huertas.

Mr Leighton at Barclays says UK groups that are run as a federated set of subsidiaries will have existing financing arrangements for much of their international business, easing the transition to ring-fencing. “But for banks running a bolt-on branch network or complex offshore structures, the intra-group lending limits will make that more difficult to manage,” he says.


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