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The Quarterly Journal of The Clearing House Q1 2015, VOLUME 3, ISSUE 1

The Future ofGlobal Banking

Foreign Banking Organizations In the U.S.

MY PERSPECTIVESally MillerInstitute of International Bankers

FBO CEO ROUNDTABLEChief executives of FBOs discuss the future of foreign banks doing business in the U.S.

IT’S TIME FOR INCREASED GLOBAL REGULATORY COORDINATIONBill WoodleyDeutsche Bank

CROSS-BORDER BANKING SINCE THE CRISISFranklin Allen, Imperial College LondonDouglas Gale, New York University

A DRAMATIC DEPARTURE? NATIONAL TREATMENT OF FOREIGN BANKSDerek M. BushCleary Gottlieb Steen & Hamilton

TCH ANALYTICSA quantitative snapshot of trends in foreign direct investment.

ALSO FEATURING

PROTECTING CONSUMERS IN A WORLD OF FASTER PAYMENTSRichard Cordray The Consumer Financial Protection Bureau

PREVENTING FRAUD IN REAL-TIME PAYMENTSDr. Leo J. LipisLipis Advisors

CYBERSECURITY COLLABORATION: ROUTES TO STRONGER DEFENSESJonathan G. Cedarbaum, WilmerHale, and Sean Reilly, The Clearing House

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HOW TO SUBMIT

Banking Perspective welcomes your submissions. Articles should be between 2,500-4,000 words and should support an identifiable position in the context of bank policy or bank payments issues. While technical in nature, articles should be clear, concise, readable, and accessible to individuals with varying degrees of knowledge of the banking industry. Authors should avoid undue focus on any individual financial firm. The Clearing House will copyedit all accepted submissions with the full cooperation of the author. The author will have final approval of all content. Once published, The Clearing House retains the right to publish and distribute material at its discretion.

To submit an article for consideration, e-mail [email protected].

HOW TO SUBSCRIBE

Banking Perspective, the quarterly journal of The Clearing House, is a forum for thought leadership from banking industry executives, regulators, academics, policy experts, industry observers, and others. Articles focus on themes in the bank regulatory landscape and innovation trends in bank payments, providing timely analysis of the most important issues shaping today’s banking industry.

To subscribe, visit: theclearinghouse.org/publications/subscribe-banking-perspective.

Coming Up for Banking PerspectiveIn the next issue, Banking Perspective will feature analysis and commentary on the opportunities and challenges banks face when it comes to managing and calculating risk. Featured authors include: Matthew Richardson, Charles Simon Professor of Applied Financial Economics at NYU Stern, on systemic risk; Patricia Jackson, Head of Financial Regulatory Advice at Ernst & Young, on conduct risk; and John Bottega, Senior Advisor to the Chief Data Officer Forum, on risk data aggregation and risk analytics.

F E A T U R E D A R T I C L E S

26 It’s Time for Increased Global Regulatory Coordination

Global regulatory coordination and cooperation are necessary to support safety, soundness and growth, but trends in global policymaking that lean toward fragmentation could hamper growth and create uneven playing fields for global banks.

by Bill Woodley, Deutsche Bank and Peter Bruzzese, Head of Government and Regulatory Affairs Department, Americas, Deutsche Bank

34 Cross-Border Banking Since the Crisis: What Does It Mean for Stability?

There are a variety of reasons for shifts in cross-border banking since the financial crisis, including monetary policy, regulation, home-country bias, and regional integration, among others. The variety of causations, however, lead to one conclusion: much more research is needed.

by Franklin Allen, Imperial College London and Douglas Gale, New York University

40 A Dramatic Departure? National Treatment of Foreign Banks

One of the most controversial elements of the Federal Reserve’s implementation of enhanced prudential standards for FBOs was its adoption of a new structural and regulatory requirement for FBOs with $50 billion or more in U.S. non-branch assets.

by Derek M. Bush, Cleary Gottlieb Steen & Hamilton LLP

50 Protecting Consumers in a World of Faster Payments

As consumers adopt faster and increasingly alternative payments methods, the payment system in the U.S. should continue to be the envy of the world, no matter the type of payment system the consumer selects. In order meet expectations, the payment system needs to have increased transparency, enhanced security, and broader access for consumers.

by Richard Cordray, Consumer Financial Protection Bureau

TCH FBO CEO Roundtable Chief executives from the U.S. subsidiaries of Barclays, HSBC, and

Mitsubishi UFJ Financial Group weigh in on the most important issues facing foreign banking organizations with operations in the United States, including the strength of the U.S. economy, the Balkanization of global markets, risk management, bank capital requirements, and more.

The Quarterly Journal of The Clearing House

1st Quarter 2015 | Volume 3, Issue 1

16

58 Preventing Fraud in Real-Time Payments

As the U.S. moves toward real-time payments, banks must adopt modern security methods to stay ahead of fraudsters. Most notably, banks must adopt true multi-factor authentication methods to secure transactions.

by Dr. Leo J. Lipis, Lipis Advisors

66 Cybersecurity Collaboration: Routes to Stronger Defenses

Although financial services has always been ahead of other industries when it comes to cyber security, banks will need to remain on their collective toes as a growing network of cyber criminals still views banking as the most lucrative target on the Internet.

by Jonathan Cederbaum, WilmerHale and Sean Reilly, The Clearing House

D E P A R T M E N T S

8 For the Record TCH Association President Paul Saltzman discusses the important

role foreign banking organizations play in the U.S. economy.

12 My Perspective The global financial markets have been significantly strengthened

since 2008, but rules in the Dodd-Frank Act have presented profound implications for FBOs operating in the United States.

by Sally Miller, Institute of International Bankers

74 TCH Analytics A snapshot of data relating to the impact of foreign banking

organizations in the United States.

76 By the Numbers A look at the economic contribution of FBOs in the United States.

78 Research Rundown Highlights from academic and policy research on issues in the

banking and payments industry.

88 Featured Moments Images from the 2014 TCH Annual Conference, as well as the

Inaugural NYU Stern-TCH Quarterly Gallatin Lecture.

94 In the Vault An early image from TCH’s 162-year past.

Banking Perspective is the quarterly journal of The Clearing House. Its aim is to inform financial industry leaders and the policymaking community on developments in bank policy and payments. The journal is a forum for thought-leadership from banking industry executives, regulators, academics, policy experts, industry observers, and others.

Established in 1853, The Clearing House is the oldest banking association and payments company in the United States. It is owned by the world’s largest commercial banks, which collectively hold more than half of all U.S. deposits and which employ over one million people in the United States and more than two million people worldwide. The Clearing House Association L.L.C. is a nonpartisan advocacy organization that represents the interests of its owner banks by developing and promoting policies to support a safe, sound and competitive banking system that serves customers and communities. Its affiliate, The Clearing House Payments Company L.L.C., which is regulated as a systemically important financial market utility, owns and operates payments technology infrastructure that provides safe and efficient payment, clearing and settlement services to financial institutions, and leads innovation and thought leadership activities for the next generation of payments. It clears almost $2 trillion each day, representing nearly half of all automated clearing house, funds transfer and check-image payments made in the U.S.

EDITOR Greg MacSweeney

Copyright 2015 The Clearing House Association L.L.C. All rights reserved. All content is owned by The Clearing House Association L.L.C. or its licensors. The views expressed herein are not necessarily those of The Clearing House Association L.L.C., its affiliates, customers or owners. Any use or reproduction of any of the contents hereof without the express written permission of The Clearing House Association L.L.C. is strictly prohibited.

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The Clearing House

Franklin Allen

Franklin Allen is the Executive Director of the Brevan Howard Centre and Professor of Finance and Economics at Imperial College London. He is on leave

from the Wharton School of the University of Pennsylvania where he is the Nippon Life Professor of Finance and Professor of Economics. Dr. Allen has been on the faculty there since 1980. He is Co-Director of the Wharton Financial Institutions Center. He was formerly Vice Dean and Director of Wharton Doctoral Programs, Executive Editor of the Review of Financial Studies and is currently Managing Editor of the Review of Finance. He received his doctorate from Oxford University. Dr. Allen’s main areas of interest are corporate finance, asset pricing, financial innovation, comparative financial systems, and financial crises. He is a co-author with Richard Brealey and Stewart Myers of the eighth through eleventh editions of the textbook Principles of Corporate Finance.

Derek M. Bush

Derek M. Bush is a partner based in the Washington, D.C. office of Cleary Gottlieb Steen & Hamilton LLP. Mr. Bush’s practice focuses on advising

domestic and international financial institutions and foreign sovereigns regarding

U.S. bank regulatory matters and legislation. His advisory practice spans a wide range of matters, including new regulatory require-ments imposed under the Dodd-Frank Act, restructurings, corporate governance and investments by and in banking organiza-tions. Mr. Bush’s practice also includes representing financial institutions in connec-tion with corporate transactions, including mergers and acquisitions, asset sales, privatizations, capital markets transactions, joint ventures and strategic alliances.

Mr. Bush received a J.D. degree, with hon-ors, from the University of Chicago, where he was an editor of the Law Review. He received an undergraduate degree, cum laude, from Princeton University in 1989. From 1994 to 1995, Mr. Bush served as law clerk to the Honorable Emilio M. Garza of the U.S. Court of Appeals for the Fifth Circuit.

Jonathan Cederbaum

Jonathan G. Cedar-baum is a partner at WilmerHale in Washington DC, based in its Government and Regulatory Litigation Group. He is also one

of the leaders of the firm’s Cybersecurity, Privacy and Communications Group and has served as outside counsel to the Clearing House’s Cybersecurity Task Force for the last three years. Mr. Cedarbaum rejoined the firm in 2011 after spending two years in the leadership of the Justice Department’s Office of Legal Counsel, where he ultimately served

as Acting Assistant Attorney General in charge of the Office, which provides authoritative legal advice to the White House, the Attorney General, and all executive branch departments and agencies. Mr. Cedarbaum has a diverse litigation practice, focusing especially on False Claims Act, Administrative Procedure Act and inter-national cases. He also counsels clients on regulatory matters and represents them before administrative agencies and congres-sional committees – particularly in the areas of data security and privacy, healthcare and financial services.

Richard Cordray

Richard Cordray serves as the first Director of the Consumer Financial Protection Bureau. He previously led the Bureau’s Enforcement Division.

Prior to joining the Bureau, Mr. Cor-dray served on the front lines of consumer protection as Ohio’s Attorney General. Mr. Cordray recovered more than $2 billion for Ohio’s retirees, investors, and business owners and took major steps to help protect its consumers from fraudulent foreclosures and financial predators. In 2010, his office responded to a record number of consumer complaints, but Mr. Cordray went further and opened that process for the first time to small businesses and non-profit organi-zations to ensure protections for even more Ohioans. To recognize his work on behalf of

Contributors

6 BANKING PERSPECTIVE QUARTER 1 2015

consumers as Attorney General, the Better Business Bureau presented Mr. Cordray with an award for promoting an ethical market-place.

Mr. Cordray also served as Ohio Treasurer and Franklin County Treasurer, two elected positions in which he led state and county banking, investment, debt, and financing ac-tivities. Mr. Cordray simultaneously created a Bankers Advisory Council to share ideas about the program with community bankers across Ohio.

Douglas Gale

Douglas Gale is a Silver Professor and Professor of Economics at New York University, where he has also served as chairman of the Department of

Economics. He has taught at the University of Cambridge, where he obtained his PhD, and at the London School of Economics, the University of Pennsylvania and MIT. He was made a Fellow of the Econometric Society in 1987, was an Extraordinary Fellow of Churchill College, Cambridge from 2003-06, and is currently a Senior Fellow of the Financial Institutions Center at the Wharton School. Dr. Gale has served on the editorial boards of Econometrica, Economic Theory, Journal of Economic Theory, Journal of Mathematical Economics, Macroeconomic Dynamics, Research in Economics, Games and Economic Behavior, Review of Economic Studies and International Journal of Central Banking. Dr. Gale is the author of several books, including Understanding Financial Crises (co-authored with Franklin Allen), and a large number of articles in leading journals on economic theory and financial economics.

Leo J. Lipis

Dr. Leo J. Lipis is the founder and chief executive of Lipis Advisors, and has nearly 20 years of experience in payment systems management, consult-

ing and research in most countries in Europe and the Americas. Prior to founding Lipis Advisors in 2007, he held positions in payments strategy and analysis at with commercial banks, clearing houses, and central banks. Dr. Lipis works chiefly in corporate and transaction banking and is responsible for the Global Payment Systems Analysis, a landmark study that compares the features and functions of dozens of payment systems around the world. Under his leadership, Lipis Advisors has completed engagements for over 100 clients on topics ranging from payment product strategy, payment system analysis and design, opera-tional improvements, risk management, and many other topics.

Sean Reilly

Sean Reilly is Senior Vice President and Associate General Counsel at The Clearing House. Mr. Reilly’s principle responsibilities center

on advising members of The Clearing House’s senior business team on vital intellectual property and technology law issues, including strategic acquisitions, industry-wide product development initiatives, and other important business transactions. Mr. Reilly also staffs various IP and technology committees, coordinating with top industry executives and senior intellectual property lawyers from the

nation’s banks on cutting edge technology law issues and initiatives of concern to the financial services industry.

Before joining The Clearing House, Mr. Reilly spent five years at the intellectual prop-erty law firm of Fitzpatrick, Cella, Harper & Scinto, advising technology and pharmaceu-tical companies on all aspects of IP law. Mr. Reilly holds a B.S. in Computer Engineering from the University of Florida and a J.D. from Fordham University. Mr. Reilly is a member of the New York and New Jersey bars, and is a registered patent attorney.

Bill Woodley

Bill Woodley is the Deputy Chief Execu-tive Officer, North America for Deutsche Bank.

Prior to his current appointment, Mr. Woodley was the Global Chief Operating Officer for Regional Man-agement from 2010 – 2013 where he served on both the Global Operating Committee and Regional Management Executive Commit-tees. Prior to this role, he was the Regional Chief Operating Officer, Asia Pacific based in Hong Kong from 2005-2010. There he chaired the regional operating and regional risk committees as well as serving as the Supervisor of the Board for Deutsche Bank (China) Co. Ltd. Mr. Woodley has also pre-viously worked in the DB Equities division where he held various roles in Equities Sales and Equity Derivatives both in New York and London. He started his career in the Royal Navy before joining Deutsche Bank in 1998.

Mr. Woodley is a British citizen, and lives with his American wife and 3 sons in Prince-ton, New Jersey.


This issue of Banking Perspective examines the issues that affect foreign banking organizations (FBOs) doing business in the U.S. in the context of international trends in financial markets and financial policy. The articles focus principally on the U.S. policy measures that have the potential to transform the business models of banks who serve global customers.

Readers also hear from Richard Cordray, Director of the Consumer Financial Protection Bureau, who describes what, in his view, are the three key pillars of consumer protection as we move towards implementation of a faster payments system: transparency, security, and access.

Globalization, the process of international cultural and commercial integration, has upended boundaries and redefined how we communicate, trade and transact with one another. The economic benefits of globalization are astounding. Despite the effects of the global financial crisis, we are, in fact, in the midst of the fastest reduction of global poverty the world has ever seen. To be sure, the number of desperately poor people living in the world today remains distressingly large, and concerns about growing income inequality persist. Yet the clear trend is toward accelerating living standards around the globe. Between 2003 and 2011, the number of global poor, as defined by the UN’s Millennium Development Goals, was more than halved, according to a 2011 report from the Brookings Institution.

Behind this process stands liberalized trade and global commerce – the freer flow

of goods and services across borders – which is eased by the availability of global financial services. Put simply, commerce on a global scale requires banks that are able to serve the financial needs of their customers on a worldwide basis. And cross-border finance, and the economic benefits derived from it, is a two-way street: the U.S. benefits both from foreign banks’ presence here and the foreign presence of U.S. banks.

To begin our examination of the role of FBOs today, it’s interesting to look back to the time when the Clearing House was first formed in the mid-1800s. In doing so, one is struck by ways in which international banking and finance was, and still is, vital to financial health and prosperity of the United States. The mid-1800s was the dawn of railroads – an industry that many economists credit with catapulting the United States into a position of international industrial leadership. Throughout the process of railroad production and expansion, the United States sought out and relied upon both domestic and foreign investment to complete its extensive construction of train tracks across the country.

By 1853, the founding year of the Clearing House, 26% of all outstanding railroad bonds were held abroad, according to Private Capital: The Transportation Revolution 1815-1860 by George Rogers Taylor. Fast forward to today. According to a 2013 Oliver Wyman report, “Enhanced Prudential Standards for Foreign Banking Organizations,” FBOs account for 40% of U.S. debt underwriting and 21% of all commercial and industrial loans made in

For the Record

PAUL SALTZMAN

President of The Clearing House Association, EVP and General Counsel of The Clearing House Payments Company


the United States. At the same time, there’s no doubt that the financial crisis revealed significant shortcomings in our regulatory approach to FBOs. However, as we go about addressing those shortcomings, we must do so in a manner that recognizes the vital role that foreign banks and foreign capital have long played in our economy.

Franklin Allen and Douglas Gale, of Imperial College in London, provide context by looking at global trends in cross-border lending in their piece, Cross-Border Banking since the Crisis: What Does it Mean for Stability? They find that banks in developed countries have retrenched, while banks in developing countries have increased cross-border lending. Interestingly, they note a decline in global integration and a simultaneous increase in regional integration.

The need for global integration, and the policy coordination required to support it, is stressed in the article authored by Bill Woodley, the Deputy Chief Executive Officer, North America for Deutsche Bank. Bill notes that, despite G20 and FSB statements with respect to harmonization, the trend appears to be toward a fragmented and uncoordinated approach. Bill provides a number of case studies that illustrate how fragmentation in global banking regulations can inhibit cross-border lending and economic growth. To achieve the goal of a safe and resilient financial system, Bill calls for international consistency and U.S. policy leadership.

U.S. policy with respect to regulating foreign banks is in the midst of historic change. The Dodd-Frank Act has transformed the regulatory landscape for all banks, and in particular for FBOs. In this issue’s My Perspective article, Sally Miller, the CEO of the Institute of International Bankers and my trade association colleague, begins by

describing the “pressures” placed on the principle of “national treatment,” whereby U.S. operations of foreign banks are treated similarly to U.S.-based banks. Sally provides a cogent summary of some regulatory departures from national treatment and the need for thoughtful consideration of the issues raised by them. She worries, quite rightly, that the “cumulative weight … will strongly incentivize FBOs to reassess their U.S. strategies … and indeed, in at least a few cases, whether they want to have a U.S. footprint at all.”

Of all the post-crisis regulatory changes for FBOs in the U.S., the most consequential is the Intermediate Holding Company (IHC) requirement under Section 165 of Dodd-Frank. This provision requires affected institutions to restructure the ownership of their U.S. operations into a single U.S. holding company. Derek Bush of Cleary, Gottlieb, Steen & Hamilton places the IHC requirement in historical context to illustrate the manner in which this is a departure from previous approaches to the regulation of FBOs. Derek agrees with Sally that the IHC requirement represents a departure from the U.S. policy of “national treatment.” This could have a global impact as other countries in turn adopt more nationalist approaches to banks, with potentially lasting consequences for cross-border banking.

In addition to the coverage of FBOs in the U.S., Banking Perspective also takes a look how consumers’ desire for faster transactions is changing the payments landscape. Director Cordray, as mentioned above, urges banks to develop payment technology and tools that can continue to drive the U.S. economy forward, while still protecting consumers. He writes that the industry should “work together to build and improved payment system that continues to enhance and be worthy of America’s powerful market economy that is the envy of the world.”

Meanwhile, two articles in the issue focus on the mounting cyber dangers that come from faster transactions and the world’s increasingly “digital” economy. Jonathan Cedarbaum, a partner at WilmerHale, and Sean Reilly, Senior Vice President and Associate General Counsel at The Clearing House, analyze how cyberattacks against banks are increasing in quantity and intensity, as cyber criminals exploit weaknesses in online security. They recommend that the public and private sectors collaborate to share threat information to keep banks and their customers safe. On a similar topic, Dr. Leo J. Lipis, founder and chief executive of Lipis Advisors, focuses on the potential for increased fraud in real-time payments, as payments providers look to meet the demands of consumers. In short, banks can help protect their customers and reduce fraud by adopting true multi-factor authentication procedures and technology, in addition to other payment safeguards that are already in use.

Finally, a highlight of the issue is the FBO CEO roundtable article, where CEOs from three banks sat down with TCH’s Jim Aramanda and me to discuss the challenges and opportunities facing global banks in the post-crisis era. Patrick Burke, President and Chief Executive of HSBC U.S., Joe Gold, Chief Executive, Americas at Barclays, and Masashi Oka, Executive Chairman, MUFG Americas Holdings Corporation and MUFG Union Bank, discussed a variety of important issues that impact FBOs, including the strengthening U.S. economy, bank capital requirements, regulatory Balkanization, and more.

Transformational change is underway in our global financial system. We must strike the right balance between shoring up the safety of the system while ensuring that it continues to support global commerce, freer trade, and worldwide prosperity.


NYU Stern-TCH Inaugural Quarterly Gallatin Lecture

FEB 6 • TCH Offices, New York

INVITATION ONLY Celebrating the shared history of New York University founder Albert Gallatin — the longest tenured Secretary of the Treasury and the inspiration for the formation of The Clearing House — NYU and TCH are launching a quarterly luncheon lecture series that will feature key thought leaders to discuss an array of different bank regulatory issues.

First Annual Operational Risk SymposiumFEB 11 • The Ritz-Carlton, Washington, D.C.

INVITATION ONLY TCH’s inaugural operational risk symposium will convene the leading thinkers and practitioners specializing in operational risk and related policy issues to cover a variety of critical topics in the space.

Brookings Institution Event: A Financial Sector to Promote Economic Growth and Stability

June TBA • Brookings Institution, Washington, D.C.

With distinguished keynote speakers and three expert panels, this event will feature a range of views contributing to a more informed public focusing on the proper role of the “new” financial sector in promoting robust economic growth and stability.

Association President Paul Saltzman Remarks at Exchequer ClubMAR 18 • Exchequer Club, Washington, D.C.

EXCHEQUER MEMBERS ONLY TCH Association President Paul Saltzman will speak on the importance of promoting financial resiliency and restoring the balance in financial reform at the Exchequer Club’s monthly luncheon series. 2014 speakers included New York State Department of Financial Services Superintendent Benjamin Lawksy, Federal Reserve Bank of Kansas City President and CEO Esther George, and other distinguished individuals.

George Washington University Federal Reserve Centennial SeriesMAR 20 • George Washington University, Washington, D.C.

INVITATION ONLY This event will explore the evolving role of the Federal Reserve in banking supervision and regulation, the new tools at its disposal for regulating the nation’s banks, and its capacity to handle the next crisis.

TCH-IIF Inaugural AML-BSA ColloquiumMAR 30 • Ronald Reagan Building and International Trade Center, Washington, D.C.

INVITATION ONLY This inaugural colloquium, in partnership with the IIF, will convene leading practitioners and regulators to evaluate the most pressing cross-border developments in the Anti-Money Laundering and Bank Secrecy Act space.

Symposium on Financial Globalization and BalkanizationAPR 21 • Imperial College, London

INVITATION ONLY This symposium will convene leading thinkers from both sides of the Atlantic to assess the implications for a global financial economy of increased and discrete regulation at the national level and whether this is precipitating a balkanization of banking.

Second NYU Stern-TCH Gallatin LectureMAY 4 • NYU Stern School of Business, New York

INVITATION ONLY The second installment in NYU and TCH’s quarterly Gallatin luncheon lecture series.

Symposium on the Intended and Unintended Consequences of Financial ReformMAY 11 • Ronald Reagan Building and International Trade Center, Washington, D.C.

Building off the success of its 2014 conference on central counterparty risk, TCH and the University of Maryland will explore the intended and unintended consequences of financial reform. The event will tackle nonbank regulation, banking system resiliency, and trends in the flight to safety.

Inaugural Financial Resiliency SymposiumMAY 28 • University of Pennsylvania, Philadelphia

This symposium will explore how to achieve a resilient banking system that is both stable and provides for robust growth.

2015 Events CalendarTHE CLEARING HOUSE ASSOCIATION


TCH-IIF Cross-Border Resolution ColloquiumJUN 5 • The Offices of Clifford Chance, London

INVITATION ONLY In its second year, this biannual series convenes senior policymakers, practitioners, bankers and academics for an in-depth dialogue on the progress that has been made, and the challenges that remain, in the development of effective cross-border resolution frameworks for globally-active banking organizations.

TCH-SIFMA 3rd Annual Bank Prudential Regulation ConferenceJUN 9 • The Offices of Covington & Burling, Washington, D.C.

This conference, now in its third year, brings together leading industry experts from regulatory agencies, Capitol Hill, banks and academia to examine prudential policy issues in today’s banking system.

Mercatus Center Event: Financing the Future: The Role of the Financial System in Fostering Economic GrowthJUN 17 • The Liaison Capitol Hotel, Washington, D.C.

This conference will provide an opportunity to consider how well the financial system is serving American consumers, savers, investors, entrepreneurs, and businesses and how the regulatory framework might be recalibrated to better facilitate higher growth.

Third NYU Stern-TCH Gallatin Lecture SEP 10 • NYU Stern School of Business, New York

INVITATION ONLY The third installment in NYU and TCH’s quarterly Gallatin luncheon lecture series.

TCH-IIF AML-BSA ColloquiumSEP 30 • London

INVITATION ONLY The second installment in TCH and IIF’s biannual AML-BSA colloquium series.

Symposium on Duties of Bank Directors and Executive Officers Through Financial Distress and ResolutionOCT 8 • University of Delaware, Wilmington

INVITATION ONLY TCH and the John L. Weinberg Center for Corporate Governance at the Alfred Lerner College of Business & Economics at the University of Delaware will host a forum to evaluate the paradigm for bank corporate governance and how the new roles and responsibilities of directors and executive officers will manifest in a financial distress and resolution scenario.

Fundamentals of Bank ComplianceOCT 14-16 • Boston University, Boston

For the second consecutive year, TCH and the Graduate Program in Banking and Financial Law at the Boston University School of Law will host a robust two-and-a-half day program providing a structural framework for understanding important trends in bank compliance.

Symposium on the Underlying Economics and Regulation of Bank Liquidity ManagementOCT 15

INVITATION ONLY This symposium will tackle the costs and benefits of the evolving liquidity regulatory framework to provide the proper incentives for bank liquidity risk management including new and proposed liquidity regulations such as the liquidity coverage ratio, net stable funding ratio, short-term wholesale funding rules, and liquidity stress testing.

Fourth NYU Stern-TCH Gallatin Lecture OCT 23 • NYU Stern School of Business, New York

INVITATION ONLY The fourth installment in NYU and TCH’s 2015 quarterly Gallatin luncheon lecture series.

Fifth Annual ConferenceNOV 16-18 • The Waldorf Astoria, New York

Now in its fifth year, TCH’s Annual Conference is the industry’s leading banking and payments conference, featuring the industry’s senior most regulators, practitioners, and experts weighing in on the most topical banking and payments issues.

TCH-IIF Cross-Border Resolution Colloquium DEC • New York

INVITATION ONLY The second installment in TCH and IIF’s colloquium series.


Significant progress has been made in strengthening the foundations of global and U.S. financial stability since 2008. In the United States, the Dodd-Frank Act (DFA) has been the centerpiece of these efforts, transforming the regulatory landscape to an extent not seen since the Great Depression. The impact has been especially significant for internationally active financial institutions as the cross-border dimensions of the crisis have prompted a heightened focus on the importance of internationally coordinated measures and appropriately calibrated domestic responses.

These developments have especially profound implications for foreign banking organizations (FBOs) operating in the United States. In particular, increased pressures have been placed on the principle of national treatment – whereby the U.S. operations of FBOs are granted parity of treatment with similarly situated U.S.-headquartered entities – long embodied in U.S. law. Principles of international comity are also being tested as provisions of DFA are sought to be applied on an extraterritorial basis.

The recent amendments to the Dodd-Frank section 716 swap “push out” provisions enacted as part of the $1.1 trillion spending bill signed into law last December provide a helpful point of orientation for understanding the national treatment issue. Despite strenuous objections by big-bank critics, there are solid public policy reasons for allowing depository institutions to retain the bulk of their swaps activities, not the least of which are to enable them to serve more effectively the credit needs of their customers, to allow

them to better risk manage their exposures through netting, and to provide more transparency and thoroughness for federal regulatory oversight. Often ignored in the debate, is the fact that these amendments were identical to those set forth in a bill that was approved by the House of Representatives with significant bipartisan support in October 2013 (H.R. 992).

Little noticed, but more important to FBOs, was the fact that these amendments also provided parity of treatment for uninsured U.S. branches and agencies of foreign banks under section 716 vis-à-vis U.S. domestic banks, thereby correcting an inadvertent breach of national treatment in the swap push out provision as originally enacted. This oversight, and the need to correct it, were acknowledged by then Senators Chris Dodd and Blanche Lincoln (the sponsor of the push out provision) in a colloquy on section 716 during the Senate’s debates on Dodd-Frank:

MRS. LINCOLN…Does my colleague agree with me about the need to include uninsured U.S. branches and agencies of foreign banks in the safe harbor of section 716? MR. DODD. Mr. President, I agree completely with Senator Lincoln’s analysis and with the need to address this issue to ensure that uninsured U.S. branches and agencies of foreign banks are treated the same as insured depository institutions under the provisions of section 716, including the safe harbor language. [Source: July 15, 2010 Senate Congressional Record.]

Nearly four-and-a-half years later, this unintended national treatment violation

My PerspectiveSARAH “SALLY” MILLER

CEO, Institute of International Bankers

Sarah (Sally) Miller is the Chief Executive Officer of the

Institute of International Bankers. The IIB’s mission is

to help resolve the many special legislative, regulatory,

tax and compliance issues confronting internationally

headquartered financial institutions that engage in

banking, securities and insurance activities in the United

States.

Prior to joining the IIB in November 2010, Ms. Miller

was a Senior Vice President at the American Bankers

Association charged with the responsibility for assisting

member banks with legislation, regulations and other

issues involving securities, trusts and investments. She

also served as Executive Director and General Counsel

for the ABA Securities Association (“ABASA”) and in that

capacity focused on investment banking, derivatives and

other similar bank capital markets activities.


‘‘was corrected in statute – a belated, but laudable outcome, to be sure.

While this development is most welcome, there are other aspects of the Dodd-Frank FBO regulatory regime that warrant further, thoughtful consideration by policymakers and, where appropriate, recalibration. Certain of these aspects raise far more serious national treatment issues, while others implicate key principles of international comity and fundamental questions regarding the extraterritorial reach of U.S. law. In either case, the need for reconsideration and recalibration is very real. Otherwise, the cumulative weight of the Dodd-Frank edifice will strongly incentivize FBOs to reassess their U.S. strategies and consider to what degree they should pull back from the provision of financial services in the U.S. – and indeed, in at least a few cases, whether they want to have a U.S. footprint at all.

In thinking about these potential policy implications, it is helpful to bear in mind the aggregate size of that footprint: FBOs currently hold more than $5.5 trillion in assets in the U. S. Twenty-five percent of all commercial and industrial loans made in this country are made through FBOs’ U.S. banking operations to manufacturers and other firms with significant numbers of employees. Four of the top ten agricultural lenders are foreign bank owned, and FBOs employ more than 200,000 individuals in the U.S. Given the significant contributions that FBOs make to the U.S. economy, a policy that inappropriately stifles foreign bank participation in the U.S. financial system is not, in America’s national interest.

One specific area ripe for reconsideration from a national treatment perspective involves the application of enhanced prudential standards (EPS) to foreign

banks under section 165 of Dodd-Frank. As described in the statute itself, section 165 was meant to cover only those “large, interconnected financial institutions” that could pose a risk to the financial stability of the U.S. Congress legislated a $50 billion “total consolidated asset” threshold for the application of the section 165 EPS. Although silent on its geographic scope, this provision has been interpreted as requiring the application of the EPS to U.S.-headquartered and foreign banking organizations alike on the basis of their global assets. This approach has produced anomalous results.

It is a peculiar sort of “national treatment” which imposes section 165 EPS requirements on more than three times as many FBOs as U.S.-headquartered bank holding companies (BHCs) – 112 FBOs versus less than 30 U.S. BHCs – even taking into account the varying degrees to which

those standards are applied to FBOs. One struggles, for example, to understand the “risk to U.S. financial stability” rationale for requiring the submission of resolution plans pursuant to section 165(d), even if “tailored” in their application, by FBOs whose U.S. operations, measured by assets, are smaller than those of many U.S. community banks. This is especially true when one considers that in almost all cases these operations are limited to uninsured branches and are subject to federal and state statutory “ring fencing” requirements intended to preserve assets available to satisfy the claims of

local third party creditors. The Institute of International Bankers (IIB) has argued, from the outset, that national treatment requires that the $50 billion threshold be based on U.S., not global assets, so that FBOs that are “large globally, but small locally” would not be captured by requirements designed solely for firms whose failure could pose a risk to U.S. financial stability.

Further, the Fed-imposed requirement that certain foreign banks with substantial U.S. operations form intermediate holding companies or IHCs, irrespective of whether they own a U.S. bank subsidiary, raises important national treatment questions. Like U.S. bank holding companies, IHCs will be subject to the Fed’s risk-based and leverage capital, liquidity and stress test requirements. However, whereas U.S. bank holding companies are permitted to take into account their global consolidated operations

in meeting these requirements, IHCs will be limited to their U.S. resources without regard to potential sources of support from the parent FBO or other affiliates.

Compounding these national treatment concerns, the Fed’s approach to IHCs raises broader questions, which have not gone unnoticed by policy makers. For example, SEC Commissioner Dan Gallagher has expressed concern regarding the “profound impact on the SEC regulated subsidiaries of large foreign banks,” that could result from the imposition of a “bank-based view

Foreign banks have had a significant presence in the United States since the 19th century and play an important role in the U.S. economy and financial markets.


of capital” on certain FBO U.S. broker-dealer operations. Commissioner Gallagher warned that this approach “will have a direct impact on the liquidity available to those operations” the net effect of which will be a reduction in the amount of liquidity in the securities markets more broadly.

And, indeed, the ink was hardly dry on the final section 165 regulations for FBOs when some large foreign banks started rethinking their U.S. strategies and taking steps to shrink their U.S. bank and broker-dealer balance sheets, by, for example, reducing their repo and securities lending businesses. Ironically, a section of Dodd-Frank intended to protect the financial stability of the U.S. threatens to have the opposite effect by pushing these businesses into the less regulated “shadow banking” sector. Notably, the migration of financial activities towards the shadow banking system was cited by the Treasury Department’s Office of Financial Research as one of three specific risks that had risen over the past year in its year-end 2014 report to Congress on threats to the financial stability of the U.S.

Policymakers should also reconsider the extraterritorial application of the Volcker Rule, which has raised significant international comity concerns among European and other foreign policymakers. To be sure, consistent with national treatment principles, the Volcker Rule prohibitions on proprietary trading and investment in private equity and hedge funds apply to FBOs doing business in the U.S., just as it applies to domestic firms. Congress, however, intended to limit the extraterritorial reach of Volcker by providing FBOs with an exemption from the Rule’s restrictions on proprietary trading and fund activities when such activities are authorized under applicable non-U.S. law “solely outside of the United States” – the so-called SOTUS

exemption. For all practical purposes, however, ongoing interpretive uncertainties have rendered the SOTUS exemption largely unworkable.

In addition, FBOs are struggling with how the Volcker Rule’s prohibitions on proprietary trading and fund investments might apply extraterritorially to funds that do not touch the U.S. and are operating legally under home country law and, as such, are excluded from the definition of “covered funds” under the Rule. This is especially frustrating as FBOs compete in their home countries with financial services providers that, by virtue of not having a U.S. presence, are not subject to the Volcker Rule. Thankfully, the Fed recently announced that it would extend the conformance period for these funds until July 2017. Hopefully, solutions to these and other difficult issues will emerge, but uncertainty and competitive inequities vis-à-vis home country providers not subject to the Volcker Rule remain for many FBOs, causing them to re-think their U.S. strategy.

Cross-border swap regulation under Title VII of Dodd-Frank also raises significant extraterritorial and comity issues. Of particular note, CFTC Staff Advisory 13-69 posits the view that a non-U.S. swap dealer must comply with CFTC transaction-level requirements when entering into a swap with another non-U.S. person if the swap is “arranged, negotiated or executed” by personnel or agents of the non-U.S. swap dealer located in the U.S. This “conduct-based” approach raises a number of troubling issues for many foreign firms, including the very significant challenges presented by developing systems and processes that would be necessary to comply with such a requirement and the very real prospect of encountering conflicts between U.S. law and foreign law

in circumstances where foreign law has the stronger claim to regulating swap activities between non-U.S. swap participants. The incentives to address these challenges by eliminating any U.S. contacts – read U.S. jobs – in connection with these ordinary course transaction are clear.

More broadly, such a conduct-based approach risks the fragmentation of liquidity pools, as already has been seen to some extent with respect to U.S. and non-U.S. trading platforms. While the substantive questions remain unresolved, the CFTC’s extension through Sept. 30, 2015 of the no-action relief previously provided on this subject, and its earlier solicitation of public comment on the questions raised by this approach, are welcome indicators of progress.

As we approach the five-year anniversary of Dodd-Frank, it’s time for Congress, the Administration and the regulatory agencies to make some sensible fixes to the Act and the way it is being implemented. Foreign banks have had a significant presence in the United States since the 19th century and look forward to continuing to play an important role in the U.S. economy and financial markets. To that end, their ability to contribute to U.S job creation and economic growth must not be frustrated by unnecessary and counter-productive legislative and regulatory hurdles that run counter to the principles of national treatment and international comity.


Opportunities Ahead

The chief executives from Barclays, HSBC US and MUFG Americas (Union Bank) sat down with The Clearing House to discuss economic trends, the regulatory outlook and the role of foreign banking organizations in the United States.

FBO CEO Roundtable

TJim Aramanda, TCH: I’ll just jump right in and kick

it off. We want to talk at a macro level and get a sense of your views on where growth is going to come from for each of your institutions given the backdrop of the global economy.

Pat Burke, HSBC: Sure. I would contrast the current environment with that of a few years ago, when many held the view that emerging markets would accelerate growth around the globe and significant Asian regional trade would follow. In short, emerging markets would grow more far more dramatically than what we would see in the West.

As we now fast forward into 2015, indeed what we’re seeing is emerging markets are continuing to provide growth opportunities though not as robustly and consistently as previously thought. And that makes

economies like the United States and the U.K. actually look like really good markets to invest in.

For HSBC, we will put quite a bit of resources and investment into the United States, simply because of the number of companies that exist in the U.S. that have international needs. There’s no other concentration of thriving companies we have in the U.S. elsewhere in the world.

Joe Gold, Barclays: I would echo that. The analogy I use for the global economy right now is the global economy’s a train, and the U.S. is the engine trying to pull along a lot of the other countries or regions. It’s the same from the perspective of a bank, which is you can see the strength of the U.S. market, it’s moving forward, it has growth to it, while in some of the other spots the investment thesis isn’t as great.


Clockwise (from top left): Patrick Burke, HSBC US, Jim Aramanda, TCH, Joe Gold, Barclays, Paul Saltzman, TCH and Masashi Oka, MUFG


And so for us growth is going to be about our U.K. business and our U.S. business. In particular in the U.S. our cards business is positioned nicely. Then also in the U.S. we’re working to rebalance some of our corporate interactions, where the U.S. companies tend to provide more growth for products. So, we’re excited about

prospects in our traditional footprint, the U.K., the U.S., and then for the rest of it are areas we’re watching and hoping for improvement, but not seeing it at the same pace.

Masashi Oka, MUFG Americas Holdings: To directly answer your question generally, I think growth in the global economy this year will depend largely on dominant developed countries like the U.S., U.K., and Germany. Others will contribute, of course – for instance, there’s easing in the EU and certain Asian countries, but for growth with global impact, we have to look to these major economies. Given my bank’s direct ties to Japan, I’m particularly mindful of the need for Japan’s economy to pick up part of the weight of global GDP growth. Fortunately, I think the Japanese economy is showing a good trend, and we anticipate its GDP will be around 1.5% or maybe a bit higher, which is better than what we’ve seen the past few years. I also think countries that have embraced structural reforms, like India, might also contribute. China of course is crucial. It showed more than 7% GDP growth last year. But we think that’s going to slow down a little, and over the mid-to-long term, we

need to watch China’s property oversupply with a bit of concern.

As far as my bank is concerned specifically, we’re very hopeful the Japanese economy will reverse its deflationary state, because we make the majority of our money in that market. But another way to view it is that 35% of our earnings come from outside Japan. With shrinking growth potential inside our home market, it’s very, very important for us to keep driving revenues and earnings outside Japan. From this perspective, which is to say our perspective, the most important growth market, globally, is right here in the U.S.

Paul Saltzman, TCH: How has the strength of the dollar lately affected the way your U.S. operations report performance, and how has that impacted your business in the United States relative to the consolidated operation?

Burke: We report in U.S. dollars. HSBC uses the U.S. dollar as its reporting currency. On top of all that is the fact that the U.S. dollar is the world’s trade and reserve currency, which makes it much easier for investors to understand the HSBC through the U.S. dollar. With respect to prospective rate hikes by the Federal Reserve, I would say most of the market probably believe that any increases in interest rates are designed for the U.S. central bank to be able to create headroom for itself should there be a slowdown in the U.S. economy.

Saltzman: Joe, does Barclays report in dollars or in pounds?

Gold: We report in sterling, not dollars. On this topic I would say there is a difference between the substance of the issue and the appearance of the issue. I think if you have a balanced business then your earnings may be changing by the difference in currency, but realistically you’re not changing the profitability. But it can be difficult explaining that, both internally and externally. Because some of our metrics, for example, our capital ratios, etc., are converted into sterling, they move around a bit. But then, when you get down to the bottom of

‘‘The global economy’s a train, and the U.S. is the engine trying to pull along a lot of the other countries or regions.

Joe Gold, Barclays

FBO CEO Roundtable: Opportunities Ahead


the equation you’ll find that the numbers don’t actually change that much because everything flows through.

Saltzman: So, it’s an added complexity for an FBO that doesn’t necessarily report to its investors in dollars. Masashi, does your bank report in yen?

Oka: Our parent MUFG reports its results in yen. MUFG Americas Holdings reports in dollars. The important issue is what impact the strengthening of the dollar has on the U.S. economy because that’s what affects our operations here. It will likely have a short-term deflationary impact, and we’re already feeling the effects of that. And a lot of commodities are priced in U.S. dollars, so that puts even more downward pressure on their prices. But energy savings should boost consumer spending and, in the longer term, the key will be employment and wage increases.

Aramanda: There are a number of strategic lenses by which to view maintaining a U.S. presence as part of a globally active bank, as all of you are. One is the client service lens. One’s the regulatory lens. One is funding related to dollar clearing. In general, how has operating an FBO in the U.S. changed since the crisis, from both a strategic and an operational perspective?

Burke: One thing surely post-crisis that we’ve all had to face is the need to, with great clarity, decide where we’re going to operate and what things we’re going to choose to focus on.

Now that we’ve got a bit more view about what we have is an ability to either take U.S. clients and help them bank throughout the world, and also help direct inward investment into the United States from non-U.S. clients. That’s the crystallization of what HSBC’s global network really is: serving the international client. It’s that focus on those particular clients that has led us to decide where we want to operate and to shed some unrelated businesses.

Saltzman: Patrick, before we move on, I want to ask you to comment on the impact of the intermediate holding company rules in the United States. If I understand it correctly, HSBC always has operated

through an organizational structure that’s congruent with the IHC rules, so they are less transformational for your bank compared to many of your peers.

Burke: That’s right. We’ve always been established as a subsidiary structure in the U.S. We’ve been independently capitalized, have a separate board, issue SEC documents, and so on, and we’ve done that for a long period of time. That means, as a result of the new rules for FBOs under Dodd-Frank Section 165, that there’s not a huge amount of change for us. Some of the resolution planning rules, those are new. Plus, we have to do them in conjunction with the resolution rules out of the U.K. at the parent company level. That’s going to be a conversation we’ll have with the various national regulators, because they don’t necessarily synch up and do the same thing.

Saltzman: How about for Barclays, Joe?

Gold: Barclays is probably on the other end of the spectrum, historically. It’s difficult for us to talk pre-crisis and post-crisis, because pre-crisis we were the pure Barclays, and post crisis we bought Lehman’s business in North America. In doing so, that changed a lot of the characteristics. But historically Barclays’ approach was to centralize as much as possible in the home branch and not be subsidiarized.

So, for us that subsidiarization is something that’s a significant change because when it came to interacting with the regulator, when it came to balancing the business and making sure that we had the right mixture of products in a geography, it was always done on a global basis. We are moving to more of regional basis today, I think that’s a substantial thing.

Saltzman: Masashi?

Oka: MUFG acquired Union Bank in the mid-1980s, so we’ve managed a national bank for 30 years. And Union Bank celebrated our 150th anniversary last year. So we have very deep roots in the U.S. on the West Coast in that regard. Our parent bank in Tokyo opened its first office in the U.S. in the 1880s, so both Union Bank


and MUFG both have deep roots in the U.S., and have been part of the U.S. banking community for well over a century.

But our various operations here have been only loosely affiliated. Since the crisis, we’ve been moving deliberately toward real integration. Last year, we combined the strengths of MUFG in the Americas with Union Bank by forming a U.S. bank holding company and a new bank, MUFG Union Bank. But this is a long process, and very complex. It’s important to note that we didn’t pursue this integration simply to comply with standards for FBOs under Section 165. Beyond that, we need to be more efficient, and most important, we need to offer our combined strengths to our customers. It’s also crucial to manage all of our U.S. operations under an enterprise-wide risk management framework. Integration lets us apply best practices from both legacy institutions, and also offer our Union Bank customers MUFG’s global reach.

Saltzman: One of the themes that we often hear from commentators is the trend towards the “Balkanization” of global markets due in part to the regulatory agenda. Is that something that concerns any of you?

Burke: I wouldn’t say we subscribe to a Balkanization view within HSBC. Our view is this: wherever trade flows occur in the world, we’ll adjust based on that. As I said at the outset, whereas we might have thought a few years ago coming off the peak of the crisis that the trade flows in a lot of the emerging markets would really explode growth rates, we now see much more restrained growth in some developed markets.

We realize places like the United States and the U.K. continue to offer really attractive growth opportunities. At the same time, I still have a strong interest in emerging markets. I know they’re going to continue to accelerate in the decades ahead, and I want to make sure I’ve got my operations focused there. From my point of view it’s a balancing of where the activity is, not a retreat, frankly, from any specific place.

Gold: I think “retreat” would be a strong statement, but I think at least from the perspective of wholesale banking and investment banking activities, you’re definitely seeing a rationalization and a change of business model.

A lot of those activities, where clients would take advantage of the global relationships, those are being rationalized because they were very painful to risk manage in a crisis. Put on top of that subsidiarization in places like the U.K., ultimately some of the IHC rules in the U.S. I think that the offering becomes one where the cross-sale of a good relationship and ability to understand the client is done globally. But actually a lot of the products end up being local. So, as a result that does change the offering, change the pricing, it changes what you can offer in some of these jurisdictions, which if you don’t have a competitive advantage then basically a bunch of banks are moving to where they have competitive advantages, or where they can provide a balanced platform.

Oka: I do think banks need to be aware who their clients are, and what they need, and for global banks that means offering global reach. We have to be able to make sure we coordinate products and services for multinational clients with overseas subsidiaries. But that goes only so far. Banks that try to be everything to all customers tend to be less efficient. You have to pick your strengths and focus on ideal markets where you can build and sustain a competitive edge. For MUFG, that’s the U.S. and Asia.

Aramanda: Of all the regulatory changes that have gone on, what sticks out as having impacted your organization the most?

Burke: I would say that the impact to both capital and liquidity, those are probably the two biggest influences of all of the regulation that’s been coming down the pike post crisis, whether it’s Dodd-Frank, whether it’s regulation in different parts of the world. It actually creates a bit of a headwind, if you will, if you’re thinking about it from a client point of view.



And indeed if you want to bring a particular product or service, however narrowly or broadly you might define that, to clients in different parts of the world, you will be running up against relatively constrained changes now in the way the regulatory environment works.

So capital and liquidity already are having an impact on the ability to do business with certain clients. Ultimately time will tell how much of an impact.

Gold: I’ll jump on the end of that. If I were to put them in order I would say it’s probably changes in risk-based capital measures, then structural reform. But I think it’s a combination of the three that causes the friction, in that you end up with certain businesses which are favorable in one and not favorable in the other, and putting them in certain jurisdictions where there’s dominance of that business. So, a client may not understand that going from a location where they have a particular type of business that is welcomed and they go to a different location, that business is difficult for us to do. And it has nothing to do with the client or the business. It has to do with the fact that we’ve layered on three different lenses to what is good business and what isn’t, and what is the balance of the other business that we have. And you add all that together, it’s difficult internally to be able to explain to people why it is that these things are in flux. To do it externally becomes incredibly confusing.

Oka: Capital and liquidity, with all the new rules, have become so important. Previously we put more emphasis on earnings, but we’ve shifted toward focusing on return – not just growth for the sake of growth, but sound and profitable growth. We’ve always emphasized safety and soundness, but now we’re emphasizing sound and profitable growth in light of the new rules. Corporate governance is very important. Enterprise-wide risk management is very important. Since we integrated operations of Union Bank and our BTMU branch in New York, changes that affect retail banking – like the Durbin Amendment and the CFPB – have become very important to all of us throughout the bank.

Saltzman: Could each of you talk about your experiences running an FBO, both the challenges

that you face from a governance and management perspective, but also some of the synergies and benefits of being part of a broader organization?

Burke: We formerly operated as a federation of regional banks more or less, and so the strategy and execution and everything was almost always done regionally. What we discovered, through the crisis, through some of the regulatory actions that have been taken, is that we have to run a global bank globally, and so we’ve created four global business lines and a related group of global business functions. However, you still can never really get away from the notion that the work is actually done on the ground in the market where you

are. So we need to find the balance between what needs to be globally driven versus what actually has to be done within any particular region or country.

Gold: Barclays is starting from a different end of the spectrum from HSBC. I would say historically, we have had more of a very pure global model. The benefit of that was whether or not the decision was made in London, New York, or Singapore, or Tokyo, it didn’t really matter because everyone was on the same page. That’s a very good benefit. The negative part of it is that from a regional perspective it was about making sure the subsidiaries were well governed.

‘‘Places like the United States, places like the U.K., they continue to offer actually really attractive growth opportunities.

Patrick Burke, HSBC US


I think we’ve actually gone from a matrix to a cube. But I always try to express to my team that you’re not in a matrix; you’re in a cube, because you have to think through every single element and every single decision from three different potential stakeholders. It adds complexity. There’s absolutely no question about this.

Oka: Balance, as my colleagues have said, is very important – striking the appropriate balance between the local governance structure and our parent’s global corporate governance framework. It’s especially important for FBOs like us. It’s very delicate work.

We’ve benefited enormously from having a very strong, independent board at Union Bank. I’ve always been able to count on our board to present credible challenges to management. In terms of risk management and governance, it’s very important to make sure our U.S. point of view is balanced with the global corporate governance framework. We need to be consistent globally as well.

Saltzman: I want to get a little granular on the funding question. How have your funding strategies changed over the years, and how do you think about it now?

Burke: We’ve always had a conservative approach to funding inside of our banking entities, in that we always like it to be deposit-led. And I really don’t think that’s going to change. I think it’s going to get a lot more challenging to be able to deliver on deposit only funding, just with the unwinding of QE. If you just think about what will happen as that takes place, by definition it will withdraw deposits from the system. How are those deposits going to be replaced? There’s still a tremendous asset growth opportunity that exists in the U.S. There’s going to be a bit of a mismatch, and therefore, core funding value is going to be probably worth more than it was a couple of years ago. I think we’ll still very much be focused on deposit funding.

Gold: Because the post-crisis issues related to funding were so quickly addressed, I wouldn’t say over the last five years we’ve seen significant changes in our plans for funding. Barclays doesn’t have a significant amount of unsecured funding requirements in the U.S., those we have we source locally, simply for the portfolio. We do have significant secured funding but that’s not that difficult to raise. So it’s about being balanced, making sure that you have a regional contingency model where you’ve got all the particular reserves and can manage it.

Oka: Of course, funding has always been very important to us. And we’ve historically been very focused on high-quality deposit-taking. Union Bank has always been strong in attracting these non-interest bearing quality deposits, and now it’s going to become more important as all banks focus on it more. We consistently do a good job in wholesale funding, because we want to make sure we have access to those markets as well. Generating funding synergies is one of the main objectives of the integration, utilizing the low-cost deposits of Union Bank to fund loans to our corporate and investment banking clients at the branch, which we previously funded by converting yen into dollars. But overall, increasing retail deposits is going to be a major focus of ours for the next few years.

Saltzman: One question that I always like to ask when I interview CEOs is your perspectives on performance metrics. When you come in every morning, what are

‘‘Financial metrics are always important. But reputation, which really comes from the culture of each bank wanting to do the right thing … I can’t overemphasize its importance.

Masashi Oka, MUFG Americas Holdings (Union Bank)



you driving towards, what’s your performance scorecard institutionally, and do you think that institutional performance scorecard differs because you’re an FBO?

Burke: I don’t know if it changes being an FBO, but the main metrics that we would look at are client-focused. How are we best serving them in a way that provides a return for our stakeholders? I want to get a global view of that. Can I do as much business with a particular client as possible? Am I doing everything in Asia that I can with that client? That’s the one we’re focused on the most. I don’t think that necessarily has anything to do with being a foreign banking organization. That’s just an ethos throughout the organization no matter where you are.

Gold: ROE, ROE, ROE. It’s ROE from an entity basis. It’s ROE from a product basis. And it’s ROE from a client perspective. I have the advantage that one of my hats is the regional hat and my other hat is I manage a lot of the lending portfolios. And we spend a lot of time investing in how do we understand the client ROE profile, both locally and globally, so should both be investing in the ones that can interact globally with us in a way that works for our platform. Then we’re trying to improve the ones that aren’t and try to just keep constant with the metric performance.

Oka: Previously we put more focus on core earnings, and that’s before tax and credit costs, with emphasis on core earnings and efficiency ratio. Our efficiency ratio is higher than some banks because we’ve focused very intensely on building a robust foundation, especially in risk management and compliance. That requires a lot of investments. But we’ve recently focused more on return, so core earnings and return are currently our two most-important measures. For return, we look at ROE, and also return on risk-weighted assets, because it’s important to look at performance on a risk-adjusted basis as well. Before my tenure as CEO, I was the first Chief Risk Officer at Union Bank, so this perspective is second nature to me.

One thing I want to point out is that all these financial measures are important, but to me personally, reputation is paramount. Strip everything else away, and banking

is built on trust. We put sincere, enormous effort into imbedding our bank’s core values into our behavior. We want to be a responsible bank; we claim to be a responsible bank; so we have to behave as a responsible bank. This builds trust and this builds business. So when customers of the largest banks nationwide were polled and named Union Bank as the most reputable bank in the nation, that was something we really took pride in.

Saltzman: That’s a good lead-in to the next question. How important have reputational risk, conduct risk, and the qualitative components of a culture of integrity become on a relative basis over the years?

Burke: They’re paramount. I think the amount of effort that we’ve put into trying to transform our culture post-crisis is important.You have to get at every single employee and make sure that they understand what we’re trying to accomplish as a firm.

And everybody individually, frankly, needs to have a view of what we’re trying to do as an organization to help our clients, and understand what our purpose is at HSBC.

Gold: Going way back in my career, I met someone who had worked at Banker’s Trust, and when we were talking about a business decision, he said, “You cannot put a value on reputation.” He said, “No matter what your numbers say, anything which gets close to that is paramount.” So, therefore we need to think of that in your risk management as the number one risk.

Oka: I agree. That’s why I wanted to bring it up, that financial metrics are always important, but reputation, which really comes from the culture of each bank wanting to do the right thing and being responsible, is the basis of banking. I can’t overemphasize its importance. It takes generations to build and it must be protected by good faith and good behavior, because it can evaporate in an instant.

Aramanda: Let’s close by trying to look forward in the future. What’s the future of global banking?


Burke: For the simple reason that, again, the clients are globalizing and the clients are internationalizing, the future for global banking is bright indeed.

Gold: I actually believe that the long term ramification of all of this change is actually much larger banks. If you look at a long term trend, our clients want a global product. And you are seeing the Balkanization reduce some of the offering. They ultimately are going to want scale in every domestic area, they’re going to want to be able to go with the most sophisticated product down to the least sophisticated product, and that’s going to lead to more actually scaling of providers over time, which is not an understood kind of outcome of this. But I think that will be the discussion four or five years from now.

Oka: I think the future of global banking is bright. All our customers are becoming more global. The U.S. is going to continue to be such an important market, and I believe we have a potential big role to play. But I do, again, believe that as FBOs we need to be committed to local markets as well, through responsible, relationship banking.

Aramanda: We appreciate it. Really, thank you a lot. This was great.



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Global Regulatory Coordination

TThe global nature of modern banking creates the need for an effective global regulatory regime designed to consistently and comparably oversee bank activities. While this notion may seem straightforward, the complexity of the global regulatory environment cuts against it. This is unfortunate because rules that undermine global consistency have consequences for the global economy which impact not only cross-border flows but ultimately impact growth. Therefore, regulatory consistency and cooperation should continue to be encouraged so that banks can compete on a level playing field and be given credit for the strength of their home country operations instead of operating with multiple layers of inconsistent rules that do not meet the goal of creating a safe financial services industry that contributes to economic growth.

Global Regulatory Coordination and Cooperation are Necessary to Support Safety, Soundness and Growth

The safety and soundness of the financial system is a critical objective that must be met to help ensure the success of the global financial system. This view is shared by the G20 leadership as they communicated the efforts that needed to be undertaken to ensure that banks and the banking system would be more resilient. In fact the G20 leadership explicitly stated that they are “committed to take action at the national and international level to raise standards together so that our national authorities implement global standards consistently in a way that ensures a level playing

by Bill Woodley, Deputy Chief Executive Officer, North America , Deutsche Bank and Peter Bruzzese, Head of Government and Regulatory Affairs Department, Americas, Deutsche Bank

It’s Time for Increased

Disclaimer: Any views and opinions expressed in this article reflect the current views of the authors, which do not necessarily correspond to the opinions of Deutsche Bank AG or its affiliates.


field and avoids fragmentation of markets, protectionism, and regulatory arbitrage.”1 On specific topics – notably capital and liquidity, and central counterparties (CCPs) – the G20’s focus and commitment to harmonization is clear.

For capital, the G20 explicitly said that building high quality capital involves a commitment to developing internationally agreed rules. Importantly, in the context of the leverage ratio, the G20 made it clear that the details of the leverage ratio should be harmonized internationally, fully adjusting for differences in accounting, and they also committed that all major G20 financial centers should adopt the Basel III Capital Framework by 2011.2

Similarly for liquidity, the G20 emphasized that strengthened liquidity risk requirements and forward-

1 Leaders’ Statement, The Pittsburgh Summit, September 24-25, 2009, page 7.


looking provisioning not only reduce incentives for excessive risk taking but also create a financial system better prepared to withstand adverse shocks.3

With respect to CCPs, the G20 committed to having all standardized over-the-counter (OTC) derivative contracts traded on exchanges or electronic trading platforms and cleared through central counterparties.4

In a similar manner, the benefits of a global approach to recovery and resolution planning were put forth by the Financial Stability Board (FSB) 5 and subsequently endorsed by the G20. This work is especially pertinent to developing a robust Total Loss Absorbing Capacity (TLAC) regime.



5 http://www.financialstabilityboard.org/wp-content/uploads/r_121102.pdf?page_moved=1, page 3.


Recently the U.S. Department of the Treasury, the European Commission (EC), and the European Securities and Markets Authority (ESMA) issued an important joint statement summarizing the developments of the U.S.-EU Financial Markets Regulatory Dialogue (FMRD).6 The statement harkens to the sentiments of strong cooperation and shared interests in continuing to implement and enforce robust, global standards, including those on the G-20 financial regulatory agenda.7

From the above it is clear that it is widely recognized that bank regulatory policy changes need to be made consistently, and global leaders have agreed to the overarching aim with overwhelming support. However, the spirit and prioritization of global cooperation and coordination has decreased as policy makers grapple with political pressures, and legislative and legal processes, resulting in a fragmented approach and uncoordinated timeframes as global frameworks are implemented nationally. Hopefully, recent examples of cross-border dialogue can be a platform for change. Multiple, potentially inconsistent and localized layers of rules do not support growth or stability but rather create an overly complicated patch work of regulation.

Fragmented Rules Appear to be a Global Policymaking Trend

Notwithstanding the history of the G20 and FSB statements on harmonization, the record belies this intent, as exemplified though a recounting of key policy decisions which move towards the negative trend of fragmented and uncoordinated approaches taken by national regulators. These approaches are often super-equivalent and do not recognize, via equivalence or mutual recognition, the regimes of other regulators. Three specific case studies highlight the missed and potential opportunities on this front: capital and liquidity, CCPs, and TLAC.

6 U.S.-EU Financial Markets Regulatory Dialogue Joint Statement, January 15, 2015.

7 U.S.-EU Financial Markets Regulatory Dialogue Joint Statement, January 15, 2015.

CASE STUDY 1

Capital and Liquidity: Unharmonized Approach to Core Requirements

Basel III Capital and U.S. LCR

Capital requirements for globally active banks via Basel III have their complexities, especially given the national implementation of these rules, but this process is well underway. Calibration is nevertheless needed to ensure global consistency and work towards balancing stability and growth. In this respect the risk weighted asset (RWA) and leverage ratio requirements will continue to play an important role in defining a bank’s capacity to intermediate credit and provide services while safely meeting regulatory demands. The RWA and leverage requirements are also intertwined with, and are the entry point, for determining the proper level of minimum Total Loss Absorbing Capacity (TLAC) under the Financial Stability Board’s (FSBs) proposal. This FSB TLAC work (discussed in detail later in the article) provides a great opportunity for globally harmonized standards.

Regardless of the potential for harmonization on the capital front, there are examples where this type of success was not attained. A prime example is the U.S. version of the globally agreed upon Liquidity Coverage Ratio (LCR). To be clear, the U.S. agencies efforts to strengthen liquidity regulations and to reduce the potential risks to the financial system that can result from the inability of a supervised organization to meet its short-term liquidity needs are absolutely necessary and must be supported. Likewise, it is reasonable to conclude that these efforts are an essential component of the overall goal of improving the resiliency of financial institutions. However, FBOs are already subject to a stringent liquidity framework under home country regulations. Moreover, the U.S. approach to the LCR is ‘super-equivalent’ to the internationally agreed upon standard and, as discussed below, does not foster global cooperation or comparability of global banking organizations.

It’s Time for Increased Global Regulatory Coordination


The U.S. approach to the LCR demonstrates how a single rule can disrupt both the alignment of global regulatory approaches and the establishment of harmonized global standards. It also obscures the comparison of the relative liquidity position of banking organizations in different jurisdictions. For example, there is a notable difference in the accelerated phase-in of the minimum LCR requirement for covered companies versus the global standard. This will be further complicated when the U.S. agencies issue an anticipated notice of proposed rulemaking (NPR) covering LCR requirements for Intermediate Holding Companies (IHCs). When that occurs, FBOs would have a global LCR plus a U.S. IHC LCR. This would equate to duplicative liquidity requirements emanating from the same core requirement. Similarly this logic applies to any of the other potential regulations that can be applied to IHC as an additional layer to the core global requirements that the present FBOs have to comply with.

CASE STUDY 2

CCPs: Uncoordinated Application of the G20 Commitment

In the U.S., the G20 commitment to CCP and derivatives regulation was largely implemented through the Dodd-Frank Act, and in the EU largely through the European Market Infrastructure Regulation (EMIR). Both sets of rules intended to ensure that as much of the over-the-counter derivatives market moved to central clearing as possible, the idea being that enhanced transparency and a more standardized market would bring stability and regulatory understanding to a complex market.

This in and of itself provided challenges resulting from nuances in national legislative processes, political climates and market players. Policy makers and regulators were forced to resolve a number of these ad hoc challenges through extraordinary action.

For example, in the margin requirements for uncleared derivatives, international consistency was ensured through the Working Group on Margin Requirements (WGMR) of the Basel Committee on Banking

Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) before national regulators finalized their respective rules in this area. The BCBS-IOSCO standards were finalized in September 2013, and both EU and the U.S. regulators have proposed rules to implement them.

However, while the national rulemakings broadly implement BCBS-IOSCO standards, there are some significant deviations from global standards which could reintroduce the prospect of regulatory divergence. The largest challenge that still remains in the derivatives space concerns recognition by one jurisdiction of another’s CCP regime. A key barrier has been a lack of mutual recognition between the EU and U.S. regimes, meaning that firms based in one jurisdiction would not be able to meet clearing mandates using CCPs based in another jurisdiction. This is problematic for perhaps the most global market, one where the two sides of the trade are very often based on the opposite sides of the Atlantic.

To date a large market disruption has only been avoided by rolling delays of the date upon which recognition requirements enter into force. This type of delay has led to significant market, investor and client uncertainty – none of these outcomes are aligned with safety and soundness and should not be allowed to permeate into other areas.

‘‘The U.S. approach to the LCR demonstrates how a single rule can disrupt both the alignment of global regulatory approaches and the establishment of harmonized global standards.


‘‘CASE STUDY 3

TLAC: An Opportunity for Harmonization

The current design of Total Loss Absorbing Capacity (TLAC) requirements, as contemplated in the recent FSB consultation paper, is a key example of a regulatory requirement that emanates from a globally objective and international agreement, but needs local level rules to implement. While the overarching objective is shared, there is a risk that fragmented, or siloed, approaches result in unnecessarily complex regimes – especially of concern to banks with home and host country regulators.

TLAC is currently at the stage where it can be the template for how global regulation can work for global firms, markets and regulators. A key question that needs careful consideration and global cooperation is deciding where in a global structure TLAC should be held. That is, it is important to ensure that TLAC is held in the right location of the group for the appropriate resolution strategy in line with an individual bank’s structure and operations. For centrally risk-managed, capitalized and funded banks, this should be single point of entry and TLAC held at group level.

To be fully effective, TLAC should be available to be down-streamed to subsidiaries in resolution. Existence of adequate intra-group arrangements to facilitate this, and regulatory criteria for allowing these to be used in a crisis, should be examined as part of resolution planning. Only if host authorities cannot agree with the resolution strategy and firm-specific cooperation agreement,

which should address intra-group arrangements, should internal TLAC be required. This is consistent with the aim that internal TLAC would promote host authority agreement on group resolution plans. However, where agreement on resolution strategies and cooperation agreements is possible, internal TLAC is unnecessary and should not automatically be required. Additionally, the question around the manner of subordination of TLAC debt should be focused upon since it would potentially create distortions between banks with different structures (i.e. banks that already have non-operating holding companies versus those without).

Therefore, regulatory harmonization is extremely important for TLAC to be successful given its pivotal role in resolution and the need for global resolution regimes. TLAC is also at a policy development stage where a positive outcome can still be achieved. It seems reasonable that the optimal way to provide certainty, clarity and stability is through a globally agreed statutory regime, likely coordinated by the FSB.

Constructive Solutions Exist to Stem the Regulatory Trend

In order to advance the dialogue on how to address regulatory fragmentation, three main solutions are worth considering. First, policy makers must agree before the proposal process to ensure that the rules meet their intent by taking into consideration possible duplication and inconsistencies across jurisdictions. They must continue to operate with this in mind throughout the regulatory development. Second, regulators must focus less on super-equivalence versus core rules that are deemed globally sufficient. Third, there needs to be greater emphasis on regulatory equivalence.

Global agreement will lead to continuity and fit-for-purpose regulations

Global policy makers should not only focus on outcomes but also on how the outcomes are achieved. This would include striving to understand the impact of rules from the perspective of domestic firms, large FBOs,

The largest challenge that still remains in the derivatives space concerns recognition by one jurisdiction of another’s CCP regime.



and universal banks that have to manage and apply rules on a multi-jurisdictional basis. This involves cooperation before, during and after the proposal process, essentially covering the full life-cycle of regulation. This process would further benefit from systemically implemented impact studies which the industry can help support to consider the multi-jurisdictional implications of the policy. It should also be complemented by more frequent and timely peer reviews and assessments. This holistic approach will be useful in justifying any divergence from the global norm and reducing the duplicative and conflicting provisions that might occur at the national level.

Core rules that are globally sufficient

The international standard must be ‘the standard’. Where there is G20 agreement on principles that are endorsed by the membership, national implementation should follow this charted course. This is not to ignore the reality that political forces, national policy-making processes or local requirements may vary by jurisdiction; however, the shared, stated objectives and global agreements should be closely aligned with the resulting rules.

If national implementation does not take into account the global dimension, then alternative, prescriptive approaches will result, as we have seen before, in fragmentation. Moreover, the use of super-equivalence to rules that are deemed globally sufficient (for example, in the U.S. Basel III and U.S. LCR and in the EU risk retention requirements and prudent valuation) do not help to advance any form of cooperation or consistency – they are by their nature intended to exceed what is deemed globally sufficient. While in some instances this may be necessary, it is not in every instance required and should not be the standard operating model for regulatory policy development.

The power of equivalence

Equivalence is the mechanism by which an authority in one jurisdiction considers the extent to which it can rely on another jurisdiction’s regulations. Equivalence

can be considered via judgments, substituted compliance, and/or mutual recognition (bilateral or multilateral agreement). International bodies should be responsible for helping to advise on equivalence to develop a transparent, consistent and efficient framework. Giving international bodies more influence over equivalence decisions would also limit the extent to which accepting foreign regimes as equal becomes a politically charged discussion.

Equivalence has a number of benefits including consistency and convergence of practices, reducing duplicative requirements, and supporting the ability of financial institutions to meet client needs for access to funding, capital, risk, and liquidity management on a global basis.

For effective equivalence agreements, there are three broad categories to note – judgment, timing and adaptation. First, the process needs to take into account that judgment will need to be assessed against different standards globally versus locally. Second, timelines must take into account implementation status in other jurisdictions. Third, adaptation requirements to meet core local legal and market requirements may differ and need to be examined. Regardless of these considerations the benefits of this approach outweigh the negatives.

Conclusion

FBOs enjoy the privilege of operating in the U.S., and note that our participation in this market is beneficial for both FBOs and the U.S. financial system. FBOs


‘‘also understand that participating in the U.S. market is accompanied by important regulatory obligations which have the distinct purpose of enhancing our safety and soundness; however, we believe that inconsistent and super-equivalent rules defeat this purpose. A level playing field makes the U.S. and the global financial system better. To achieve this important goal, international consistency and U.S. policy leadership are necessary. As a leader, U.S. policy makers should take a global view of the regulatory landscape to ensure that banks are safer, more comparable and resolvable while accounting for the fact that regulatory divergence in national implementation obstructs this goal.

That said, it should be noted that a significant amount of work has been done, and is being finalized, to ensure that no bank is too big to fail. This includes significantly enhanced prudential regulation (capital, liquidity and leverage rules) and increased capital buffers for the largest banks. Many of the specific policy recommendations and rules are proof that change is underway and resilience is growing; time is needed for these changes to be implemented and demonstrate their full benefits.

Consistency and a level playing field seem to be reasonable goals to achieve in the bank regulation policy sphere. In judging whether FBOs meet the required U.S. standards, the fact that FBOs are a part of a bigger group should be given credit. Without this, the current path

will inevitably continue. Hopefully, future developments will take these concerns into account and will lead to an improved way forward.

If national implementation does not take into account the global dimension, then alternative, prescriptive approaches will result, as we have seen before, in fragmentation.



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WWhat dynamics and level of integration would make for the most efficient and stable global capital market? It’s an ambitious question, but as a start let’s examine the patterns around the financial crisis. The increase in international capital flows before 2008 and the decline afterwards have been widely documented. Changes in cross-border banking flows made up a substantial part of this rise and fall.

Breaking down the data by country reveals two main trends. Banks in developed countries, particularly in Europe and the United States, retrenched and cross-border claims fell, but banks based in emerging economies actually increased cross-border lending, as illustrated in Figure 1. Another interesting contrast is that while global integration in banking declined, regional integration increased.

The crisis particularly affected cross-border flows in the eurozone, as research from the Bank for International Settlements (2012) and Bologna and Caccavio (2014) found. Gross consolidated foreign claims of eurozone countries decreased by 35 percent from the peak in March 2008 to the trough in June 2012. Claims from eurozone countries on other eurozone countries fell by 40 percent compared to 32 percent for claims from eurozone countries to non-eurozone countries. These average numbers hide a huge variation; the changes in individual countries range from a fall of eight percent for Portuguese banks to 80 percent for Belgian banks.

by Franklin Allen, Imperial College London and Douglas Gale, New York University

What Does It Mean for Stability?

Cross-Border Banking Since the Crisis


After the crisis the absolute number of banks operating in foreign countries fell, but the foreign banks share remained the same, at about 35 percent. Although the total number of foreign banks entering new countries fell to about one fifth of what it was pre-crisis, the number of domestic banks also fell. Claessens and Van Horen (2014) document the aggregate data and the sharp differences across countries. Again, there is significant variation. In 66 host countries the number of foreign banks fell, but in 48 it increased. Banks from emerging countries were responsible for over two thirds of new entries. In addition, the average intra-regional share increased by five percent.

Emerging markets banks were expanding abroad even before the crisis, and this trend has continued. Their role increased as well-capitalized emerging-country banks

were able to purchase interests from developed-country banks in the aftermath of the crisis. Claessens and Van Horen give the examples of Russia’s Sberbank buying the Central and Eastern European subsidiaries of Austria’s Volksbank; Chile’s Corpbanca buying Santander’s Colombian; and HSBC selling its interests in Costa Rica, El Salvador, and Honduras to Banco Davivienda of Colombia. Overall, emerging-country banks increased their share of foreign banks assets from four percent to eight percent, while the banks within the Organisation for Economic Co-operation and Development (OECD) decreased their share by six percent.

Academic literature has emphasized four explanations for the changes in cross-border lending, which we will now consider in turn.


‘‘The Crisis Itself Changed the Nature of Cross-Border Banking

Considerable evidence demonstrates the crisis itself significantly affected the willingness of banks to lend across borders. Claessens and Van Horen (2014) found that banks with headquarters located in a crisis country are more likely to have exited from any host country. De Haas and Lelyveld (2010) found that foreign banks were more willing to support their subsidiaries when the host country was in crisis and the bank’s home country was not. Research from BIS (2012) and Bologna and Caccavio (2014) suggests that the eurozone has been particularly affected due to the difficulty of hedging the risk of a eurozone break-up, except by balancing assets and liabilities country by country.

Claessens and Van Horen (2014) found that banks are more likely to exit: when the host country is less developed; when the home country is more developed; when home country banks have a small share of the host country market; and when the distance between the two countries is large. Not surprisingly, entry is higher when real GDP growth is greater – and this turns out to be the main determining factor. Growth in assets of banks that are already established in a foreign country is driven by a wide range of host country characteristics and conditions.

Changes in Regulation Affected the Willingness of Banks to Lend Across Borders

In theory the impact of new regulation on cross-border lending can go either way, as Houston, Lin and Ma (2012) point out. On one hand, banks may be attracted to cross-border lending if the host country has less restrictive regulations than the home country. On the other, stricter regulatory requirements in the home country may make foreign lending more expensive. Bremus and Fratzscher (2014) find that increasing capital requirements in the home country reduces cross-border claims. They argue that regulators must implement new rules across countries in a transparent and harmonized way in order to avoid further reductions in cross-border banking.

Central Bank Actions Affected International Banking

Many have argued that loose monetary policy since the crisis has been an important factor in cross-border flows. Bruno and Shin (2014) develop a model of global liquidity built around the operation of global banks. These finance cross-border lending to local banks by borrowing U.S. dollars from money market funds in financial centers. The local banks lend to the ultimate borrowers in U.S. dollars. The local banks then invest in local currency assets and so create a currency mismatch. When the local currency appreciates (that is, the U.S. dollar depreciates) the ultimate borrowers’ balance sheets become stronger, and local banks can lend more to them. Local currency appreciation thus leads to increased risk-taking by banks. When there is local currency depreciation, on the other hand, the process reverses. Banks deleverage and cut loans, threating financial stability.

Loosening of U.S. monetary policy dollar can lead to depreciation against some currencies and increased cross-border lending. Appreciation of currencies can lead to reductions in cross-border lending. Bruno and Shin use data from 46 countries and find support for their

After the crisis the absolute number of banks operating in foreign countries fell, but the foreign banks share remained the same, at about 35%.

What Does It Mean for Stability? Cross-Border Banking Since the Crisis


‘‘The crisis itself significantly affected the willingness of banks to lend across borders.

model. This theory is one potential explanation for the wide heterogeneity, since the crisis, in cross-border bank lending to emerging countries, with lending to some countries going up and to many other countries going down. In many emerging countries, local currencies have strengthened against the U.S. dollar, while in many countries currencies have weakened.

The Resolution of Cross-Border Banks Proved Problematic

The lack of a global resolution mechanism has been a significant determinant of cross-border lending, according to much research, e.g. Cerutti, Claessens and McGuire (2012) – again, particularly so in the eurozone, as Manna (2011) points out. It is a commonplace to say that banks are global in life, but national in death. As a result, national regulators have an incentive to limit cross-border lending (The Economist, 2012). After the default of Lehman Brothers, this factor seems to have become significantly more important.

What should we look at next?

This overview suggests some broad trends, but the data on cross-border banking is complex and interpreting it is challenging. Drawing firm conclusions is premature at best and foolhardy at worst. The currently available data is just a rough measure of cross-border banking activity. The size of the cross-border flows is important, but the data hide a great deal of qualitative information about the many activities that banks engage in. Apart from correlations that reveal the ebb and flow of lending from countries of different sizes, locations, and levels of development, there is little hard data that bears directly on the causal factors driving these changes. To conclude, we outline some of the most interesting and important questions posed by the data and the kinds of research that could settle the related policy questions.

Are capital flows the right measure of globalization, or are there qualitative dimensions that should be taken into account?

Efficient risk-sharing implies a particular pattern of capital flows among countries, where countries in recession receive flows from countries in the boom. Macroeconomists have documented the failure of capital markets to provide this kind of insurance, but the possibility reminds us that it matters, for the allocation of risk and resources, whether Country A is receiving funds from Country B or Country C.

Does greater regional integration lead to greater stability?

Looking at the big picture of global financial stability, the efficiency of cross-border lending can only be evaluated if one knows the risks being shared, the correlation of those risks, the productivity of firms and industries being funded, the cost and maturity of the debt, the types of controls exercised by the lender through covenants and monitoring, and other factors. Because this data has not been collected, the jury is still out.

Does the retrenchment of the banks in developed countries make the global system more stable?

The retrenchment by banks based in developed countries and the expansion of banks based in emerging


countries represent a replacement of one set of banks by another, but it may also represent a shift from one set of borrowers to another. The aggregate data in the studies to date does not reveal what kind of reallocation has occurred. Whether it has increased the efficiency of the global financial system is anyone’s guess.

Even if improved regulation and higher standards in developed countries makes individual banks stronger, does greater fragmentation of the global system add to stability or simply reduce risk-sharing?

As recent theoretical research on financial networks makes clear, greater connectivity can promote diversification, if the shocks are not too great, and this is

one of the virtues of globalization when it works well. But greater connectivity can be a transmitter of shocks that, if the shocks are large enough, will destabilize the system. Similarly, greater integration of regional economies may concentrate risk and leave countries more exposed to shocks emanating from their neighbors, whose economies are highly correlated with their own.

Another qualitative dimension of the aggregate changes observed in the data relates to the services provided by different banks. Financial institutions from developed countries, especially the very largest banks, provide a range of services that cannot be duplicated by most banks in emerging markets. It may be that these services are not needed in some parts of the world are best restricted to their host countries. On the other hand, large banks like to say that their customers want to deal with a bank that can provide “one-stop shopping” for financial services and can provide these services globally,

What Does It Mean for Stability? Cross-Border Banking Since the Crisis

2001

0

2

Tota

l cla

imes

in t

r. U

SD

4

6

2003 2005 2007 2009 2011

All EM (Emerging Markets) EA (Eurozone Area)

Source: Figure 1a from Bremus and Fratzscher (2014).


wherever their customer, often a multi-national firm, operates. A decrease in globalization could involve a cost born by those corporate customers.

What explains the changes in cross-border lending that we have observed?

We have mentioned a number of theories. Each of them may be relevant in some countries and not in others. One calls for stricter macro-prudential regulation in developed countries. As banks have been forced to raise more capital and hold more high quality liquid assets, or else shrink their balance sheets and obtain more long term funding, they have found it expedient to reduce their involvement in emerging markets. The Great Recession reduced growth and profits in many parts of the world and that has had knock-on effect on borrowing. The sovereign debt crisis in the eurozone has had a direct impact on cross-border lending as banks in the southern periphery have loaded up on the debt of their own government, and banks in the northern core have shed the debt of the southern. But the stress that was felt by the eurozone banking system must have had wider repercussions on lending to emerging markets or indeed to any country outside the eurozone.

The issue of causation is interesting and important in itself. This also depends on the qualitative dimension of the changes in global capital flows, because banks in different parts of the world are not perfect substitutes and because lending from different parts of the world has different implications for risk sharing and stability. Much more research is needed before we can understand the implications, for efficiency and stability, of the changing tides and eddies of the global capital market.

REFERENCES

Bank for International Settlements (2012), “Detailed tables on preliminary locational and consolidated banking statistics at end-June 2012’, October, Table 9, http://www.bis.org/statistics/consstats.htm.

Bologna, P. and M. Caccavaio (2014). “Euro Area (cross-border?) banking,” Questioni di Economia e Finanza Number 228, Banca d’Italia.

Bremus, F. and M. Fratzscher (2014). “Drivers of Structural Change in Cross-Border Banking since the Global Financial Crisis,” DIW Berlin, Discussion Paper 1411.

Bruno, V. and H. Shin (2014). “Cross-border Banking and Global Liquidity,” Review of Economic Studies forthcoming, BIS Working Paper 458.

Cerutti, E., S. Claessens and P. McGuire (2012). “Systemic Risks in Global Banking: What Can Available Data Tell Us and What More Data are Needed?” BIS Working Paper 376.

Claessens, S. and N. Van Horen (2014). “The Impact of the Global Financial Crisis on Banking Globalization,” IMF Working Paper 14/197.

De Haas, R., and I. Van Lelyveld (2010). “Internal Capital Markets and Lending by Multinational Bank Subsidiaries,” Journal of Financial Intermediation 19, 689-721.

Houston, J.F., Lin, C. and Y. Ma (2012). “Regulatory Arbitrage and International Bank Flows,” Journal of Finance 67, 1845-1895.

Manna, M. (2011). “Home bias in interbank lending and banks’ resolution regimes,” Temi di discussion 816, Banca d’Italia.

Milesi‐Ferretti, G. and C. Tille (2011). “The Great Retrenchment: International Capital Flows During the Global Financial Crisis,” Economic Policy, 26(66), 285-342.

The Economist (2012): The retreat from everywhere, April 21, available at http://www.economist.com/node/21553015/print

Van Horen, N. (2011), “The changing role of emerging market banks,” in T. Beck (ed.), The Future of Banking, CEPR/VoxEU-eBook, 79-83.


A Dramatic Departure?National Treatment of Foreign Banks

A Dramatic Departure?National Treatment of Foreign Banks


OOne of the most controversial elements of the Federal Reserve Board’s implementation of enhanced prudential standards for foreign banking organizations is a new structural requirement. The final rule requires FBOs with $50 billion or more in U.S. non-branch assets to restructure the ownership of their U.S. subsidiaries into a single “intermediate holding company,” regulated as a U.S. bank holding company whether or not it owns a U.S. bank.

Some commenters have characterized the IHC requirement as a dramatic departure from historical U.S. approaches to cross-border banking supervision and regulation; former Rep. Spencer Bachus described it as having “eradicated decades of codified law and regulatory practice in international banking,”1 It certainly stands out as a noteworthy decision in the FRB’s post-financial crisis policymaking.

The IHC requirement represents a subtle but profound change in policy toward cross-border banking, with consequences that are farther reaching and of broader relevance than the more obvious and intentional departures from past practice (such as eliminating organizational variation and imposing bank regulatory capital requirements on activities conducted through nonbank subsidiaries). The FRB explicitly notes that it based the requirement on changed goals, such as reducing reliance on parent bank/home country support. However, the requirement marks a distinct shift, which this article will put into an historical context, away from the U.S. policy of parity between foreign and domestic banks in similar circumstances, known as “national treatment.”

Historical Approaches to U.S. Regulation of Foreign Banks

Four key milestones mark the development of U.S. federal regulation of foreign banks before the most recent financial crisis: the International Banking Act of 1978,2 the Foreign Bank Supervision Enhancement Act of 1991,3 the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994,4 and the Gramm-Leach-Bliley Act of 1999.5 Each changed the structure

1 Letter from Rep. Spencer Bachus, dated Mar. 14, 2013.

2 Pub. L. No. 95-369, 92 Stat. 607 (1978).

3 Pub. L. No. 102-242, Title II, 105 Stat. 2286 (1991).

4 Pub. L. No. 103-328, 108 Stat. 2338 (1994).

5 Pub. L. No. 106-102, 113 Stat. 1338 (1999).

by Derek M. Bush, Cleary Gottlieb Steen & Hamilton LLP


and extent of foreign bank regulation in different and meaningful ways, and yet all four were guided by the principle of national treatment for foreign banks.

THE INTERNATIONAL BANKING ACT OF 1978

The IBA established the foundation for modern U.S. regulation of foreign banks. Until the late 1970s, the bank regulatory framework for most foreign banks’ U.S. operations derived largely from state bank powers and licensing laws. Unless a foreign bank controlled a U.S. bank subsidiary, it generally was not subject to Bank Holding Company Act limitations on nonbank activities and investments or subject to restrictions on interstate branching. As foreign banks’ presence in U.S. markets grew during this period, a concern emerged that this lack of regulation created a competitive advantage for

foreign banks. At the same time, it became apparent that a largely state law-based regulatory regime for foreign banks did not afford foreign banks the full benefits of the U.S. “dual banking system.”

The IBA overhauled the U.S. regulatory framework for foreign banks operating through branches in the United States, bringing them under centralized federal oversight by the FRB for the first time. These foreign banks became subject to BHC Act restrictions on nonbanking activities and investments in the United States and restrictions on interstate expansion (with grandfathering of existing

operations).6 Branches also became subject to federal law reserve requirements.7

At the same time, the IBA created new opportunities for foreign banks by allowing branches to obtain FDIC deposit insurance for retail deposits8 and by allowing foreign banks to obtain a federal branch license from the Office of the Comptroller of the Currency.9 Federal branches were to be subject to the same powers and restrictions as national banks, with some exceptions, such as an adjustment allowing restrictions based on capital stock and surplus (e.g. lending limits) to be based on the consolidated capital stock and surplus of the foreign bank.10 The IBA also authorized the OCC to waive U.S. citizenship requirements for national bank directors (up to a minority of the directors) for national banks owned by foreign banks.11

Congress’ explicit guiding principle behind the IBA’s approach to foreign bank regulation, endorsed by the FRB at the time, was a non-discrimination principle of “national treatment and equality of competitive opportunity.”12 The IBA’s concept of national treatment, as it has been understood at least since 1978, entails “parity of treatment between foreign and domestic banks in like circumstances.”13 As a policy objective, national treatment is designed not just to promote fairness but also to improve availability of financial services and competition in banking markets.14 National treatment

6 IBA § 5(a).

7 IBA § 7. In this article, we have not distinguished between branches and agencies of foreign banks, as the distinction is not relevant to the analysis.

8 IBA § 6. FBSEA later constrained this ability, as noted below.

9 IBA § 4.

10 IBA § 4(b).

11 IBA § 2.

12 At various times, national treatment and competitive equality have been articulated as two principles or parts of one principle, and in some contexts one but not the other is mentioned.

13 S. Rep. No. 95-1073, at 2 (1978), reprinted in 1978 U.S.C.C.A.N. 1421, 1422.

14 See Remarks of William J. McDonough, President of the Federal Reserve Bank of New York, March 23, 1996.

A Dramatic Departure? National Treatment of Foreign Banks

‘‘The IHC requirement represents a subtle but profound change in policy toward cross-border banking, with consequences that are farther reaching.


also facilitates U.S. banking organizations’ ability to expand into non-U.S. markets where they would expect comparable national treatment to be applied to them, and strengthens the U.S. government’s hand in free trade and other treaty negotiations over access to local financial services markets for U.S. banks.15

As illustrated by the IBA, national treatment is a double-edged sword. It gives foreign banks the benefits of opportunities available to domestic banks, but it imposes restrictions designed to be comparable to those that apply to domestic banks, taking into account applicable differences in circumstances.

FOREIGN BANK SUPERVISION ENHANCEMENT ACT OF 1991

Congress passed FBSEA in the wake of the collapse of Bank of Commerce Credit International and a scandal involving Banca Nazionale de Lavoro, and following the savings and loan crisis of the late 1980s and a number of significant commercial bank failures in the same period. The FRB requested from Congress, and received, broad new supervisory authority over foreign banks, including a requirement that all new branches (whether state or federally licensed) obtain prior FRB approval under newly tightened statutory standards, including that foreign banks be subject to comprehensive supervision or regulation on a consolidated basis by home country authorities.16 FBSEA also gave the FRB direct examination authority over both federal and state branches of foreign banks.17

In a provision tracking a similar development for FDIC-insured state banks, FBSEA also limited the powers of state-licensed branches by providing that no state-licensed branch could engage in activities not permitted for a federal branch, and subjected state branches to

15 Roll-up Study, infra n. 20, at 4-5; see also, e.g., North American Free Trade Agreement, U.S.-Can.-Mex., Dec. 17, 1992, 32 I.L.M. 605 (1993).

16 FBSEA § 202.

17 FBSEA § 203(a).

the same lending limits as federally licensed branches.18 FBSEA also curtailed foreign banks’ ability to establish branches authorized to take FDIC-insured deposits, grandfathering the relatively small number of existing FDIC-insured branches.19

Of particular relevance to the FRB’s later consideration of the IHC requirement, FBSEA required the Treasury Secretary and the FRB to study “whether foreign banks should be required to conduct banking operations in the United States through subsidiaries rather than branches.”20 In their report following the study (the “Roll-up Study”),21 the Treasury Secretary and the FRB recommended against such a requirement, in part because it would be inconsistent with national treatment.22 The study confirmed that any branch roll-up requirement (now known as subsidiarization) would require a change in law.

RIEGLE-NEAL INTERSTATE BANKING AND BRANCHING EFFICIENCY ACT OF 1994

Unlike the IBA and FBSEA, Riegle-Neal did not target foreign banks’ U.S. operations. On the contrary, Riegle-Neal’s relaxation of restrictions on interstate banking and branching was designed primarily to reduce restrictions on U.S. banking organizations. Consistent with the national treatment principle, Congress provided for comparable treatment for foreign banks operating branches in the United States, allowing foreign banks to establish branches outside of their home states under circumstances similar to the ones required for U.S. banks to branch across state lines. This required some adaptation, through the FRB’s rulemaking process, to take into account structural differences between foreign banks and U.S. banks, including the fact that interstate branching would involve establishment of an additional

18 FBSEA § 202(a).

19 FBSEA § 214(a).

20 FBSEA § 215.

21 Department of the Treasury and FRB, “Subsidiary Requirement Study” (Dec. 1992).

22 See Roll-up Study at 4.


branch by the foreign bank (not one U.S. branch establishing another branch in another state).

Although Congress designed the foreign bank provisions of Rielgle-Neal to be consistent with national treatment for foreign banks, there were stages in the legislative process when that outcome was less clear. The Kentucky Bankers Association led an effort, which succeeded for a time in the Senate, to require that foreign banks roll-up their U.S. branches into bank subsidiaries in order to branch across state lines. The Treasury Secretary weighed in against the provision based on concerns that it would be inconsistent with national treatment and could invite retaliation against U.S. banks abroad.23 The proponents of the roll-up requirement argued that it was necessary to preserve competitive equality, because in order to branch across state lines

U.S. banks by necessity were required to be organized as separately incorporated and capitalized banks.

What this argument ignored, however, is the feature of national treatment that requires comparable treatment of U.S. and foreign institutions “in like circumstances.” By defining the non-discrimination equation in a way that ignored the character of a foreign bank’s operations, and forcing foreign banks to restructure their operations into a U.S. subsidiary model, the proponents of the roll-up requirement had oversimplified the national treatment equation. They essentially argued that comparable

23 Letter from Treasury Secretary Newman, dated Feb. 22, 1994.

treatment required a comparable structure, which was inconsistent with the concept of national treatment in previous legislation and the Roll-up Study. Ultimately, the provision was eliminated in conference committee, and national treatment as it traditionally had been understood was preserved.

GRAMM-LEACH-BLILEY ACT OF 1999

Like Riegle-Neal, GLBA and its provisions allowing qualifying BHCs known as “financial holding companies” to engage in an expanded range of financial activities were designed mainly to reduce restrictions on domestic banking organizations. Consistent with the principle of national treatment, GLBA also made these advantages available to FBOs. In general, the task of extending these benefits was more straightforward in GLBA than in Riegle-Neal, because the structural differences between U.S. BHCs and FBOs did not significantly matter in the expansion of activities related to U.S. nonbank subsidiaries and investments.

GLBA’s criteria for an FBO to qualify as an FHC required some interpretation. The criteria for U.S. BHCs were based on the “well managed” and “well capitalized” status of their U.S. bank subsidiaries, but the relevant tests needed to be adapted to foreign banks with U.S. branches and agencies. GLBA directed the FRB to apply “comparable capital and management standards to a foreign bank that operates a branch … in the United States, giving due regard to the principle of national treatment and equality of competitive opportunity.”24

In implementing this provision of GLBA, the FRB determined to look primarily to foreign banks’ home country consolidated capital to determine whether they were “well capitalized” and to their U.S. branch supervisory ratings to determine whether they were “well managed.” This represented an adaptation from the U.S. standards, but it was viewed as consistent with

24 GLBA § 103(a), 12 U.S.C. § 1843(l)(3).

‘‘The IHC requirement requires FBOs with $50 billion or more in total U.S. non-branch assets to restructure the ownership of their U.S. subsidiaries into a single U.S. IHC.



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national treatment, taking into account the different circumstances of foreign versus domestic banks.25

Dodd-Frank Act and Enhanced Prudential Standards

On its face, the statutory language of the enhanced prudential standards provisions of Dodd-Frank Act section 165 appears to align neatly with the milestones reviewed above. It authorizes the FRB to develop EPS in the areas of risk-based and leverage capital, capital planning and stress testing, liquidity, risk management, and single counterparty credit limits, for both U.S. BHCs and FBOs that meet applicable size thresholds. In the case of FBOs, the FRB is required to “give due regard to the principle of national treatment and equality of competitive opportunity,”26 a standard that tracks the comparable GLBA provision. For this reason, among others, foreign banks generally expected that the implementation would involve a typical exercise in adapting U.S.-based EPS to the cross-border nature of foreign banks operating in the United States. For example, by analogy to the IBA’s federal branch lending limit provisions, FBOs expected that a single-counterparty credit limit for foreign banks would look to aggregate exposures of a foreign bank’s U.S. operations measured as a percentage of the foreign bank’s consolidated capital and surplus.

THE FRB’S EPS RULE AND THE IHC REQUIREMENT

Some aspects of the FRB’s regulation implementing section 165 followed this expected path for applying the U.S. national treatment principle, consistent with

25 See 65 Fed. Reg. 3785, 3788 (Jan. 25, 2000) (interim rule); 66 Fed. Reg. 400, 408 (Jan. 3, 2001) (final rule).

26 Dodd-Frank Act § 165(b)(2). The FRB is also required to “take into account the extent to which the foreign financial company is subject on a consolidated basis to home country standards that are comparable to those applied to financial companies in the United States,” which became a separate point of controversy in the rulemaking process relating to the IHC requirement.

historical U.S. approaches to similar requirements. Some, including the IHC requirement, did not.

When FRB Governor Daniel Tarullo foreshadowed the IHC requirement in a speech at Yale University in November 2012, he specifically referred to the U.S. policy of national treatment, which he defined as treating a “foreign-owned service provider no less favorably than like domestic service providers.” Tarullo noted that “of course, differences in business organization, domestic regulatory systems, and other factors mean that there must sometimes be determinations whether foreign and domestic firms are ‘like’ one another in relevant respects.”27 In the rulemaking process, however, the issue of national treatment, and the question of “like” foreign and domestic firms, became a particular topic of controversy in relation to the IHC requirement.

As implemented, the IHC requirement requires FBOs with $50 billion or more in total U.S. non-branch assets (assets in essentially all U.S. subsidiaries) to restructure the ownership of their U.S. subsidiaries into a single U.S. IHC. The IHC would be supervised and regulated by the FRB, and subject to EPS as well as ordinary course FRB regulatory and reporting requirements as if it were a U.S. BHC (whether or not the IHC owns a U.S. bank).

The purposes of the IHC requirement articulated by the FRB were several-fold. Among other things, the IHC addressed the FRB’s concerns that in the environment following the financial crisis, it was no longer realistic to assume, as previous policies had done, that a parent foreign bank would (or could) support its U.S. operations in times of stress. The FRB also observed that the U.S. operations of FBOs “became increasingly concentrated, interconnected, and complex after the mid-1990s,” justifying a change in regulatory approach. The IHC requirement also was motivated by concerns about the capital adequacy of broker-dealer subsidiaries of foreign banks regulated by the Securities and Exchange Commission, some of which are large and play a significant role in U.S. markets. In addition, the IHC requirement would, in the FRB’s view, provide a

27 Remarks of FRB Governor Tarullo, Nov. 28, 2012.



uniform platform for the supervision and regulation of U.S. subsidiaries of foreign banks in a format that more closely resembled the structure of U.S. BHCs. The FRB also suggested that the IHC structure would facilitate an orderly cross-border resolution of an FBO.28

SHIFT IN APPLICATION OF THE NATIONAL TREATMENT PRINCIPLE

When viewed in historical context, the IHC requirement indicates a distinct shift in the FRB’s application of the national treatment principle. Discussion about national treatment featured prominently in the rulemaking process – in both industry objections and the FRB’s response. In the preamble to the final rule, the FRB stated that “the principles of national treatment and equality of competitive opportunity were central considerations in the design of the enhanced prudential standards for foreign banking organizations.”29

From the foreign banks’ perspective, the IHC requirement contravened national treatment because it did not treat foreign banks operating in the United States comparably to U.S. BHCs (e.g. did not apply or adapt EPS on a consolidated basis, and applied capital and other requirements on a sub-consolidated level). From the FRB’s perspective, the IHC requirement was consistent with national treatment because IHCs would be subject to a regulatory framework, including EPS, that was comparable to the framework that applies to U.S. BHCs. These perspectives in the end appeared to be two ships passing in the night, as the foreign banks and the FRB defined the relevant equation differently.

It is this difference – in how national treatment was applied in practice – that marked the most distinct shift from historical approaches. As traditionally articulated, and as phrased by Tarullo in his speech at Yale, national treatment is defined as comparable treatment for domestic and foreign institutions “in like circumstances.” For the FRB in designing the IHC requirement, the

28 79 Fed. Reg. 17240 17264-17269 (Mar. 27, 2014) (final rule).

29 79 Fed. Reg. at 17268.

institutions in like circumstances were U.S. BHCs and IHCs. As long as the treatment between these two groups was comparable, national treatment was achieved. However, like virtually any non-discrimination question, the rub lies in how like circumstances are defined. For the foreign banks, IHCs could only be viewed as in like circumstances with U.S. BHCs if one were to first force

an FBO’s U.S. subsidiaries into a BHC-like structure, akin to the roll-up requirements that had previously been rejected on national treatment grounds, and then ignore the fact that an IHC is a subgroup of a consolidated FBO, which itself is subject to consolidated capital, liquidity, and other prudential requirements.

The FRB’s articulation of the national treatment equation as based on the structure and regulation of the U.S. operations of a foreign bank in isolation, without regard to their ownership by, and role as part of, a foreign bank, is precisely the point at which the shift in application of national treatment occurred.

One can also illustrate this shift by applying the FRB’s “new” national treatment principle backwards through the historical context described above. For example, if the FRB’s current views of national treatment had been applied in the context of the IBA, Congress would not have given the OCC authority to waive director citizenship requirements for national banks owned by FBOs in the name of national treatment. A national bank owned by a U.S. BHC is – at the level of the national bank – no different than a national bank owned by an

‘‘National treatment has been a U.S. policy priority because it strengthens our government’s hand in trade negotiations where access to financial markets is at issue.


FBO. It is only because of the national bank’s ownership by, and role as part of, an FBO, that the need for such an adaption becomes appropriate. Similarly, Congress’ decision to measure a federal branch’s lending limit as a percentage of the foreign bank’s consolidated capital is an adaption that is based on an understanding of the federal branch’s role as part of a foreign bank; otherwise, in theory a federal branch’s loans would need to be limited to some measure of deemed capital of the branch itself based on the branch’s balance sheet. Lastly, when the Kentucky Bankers Association pressed to require foreign banks to operate through bank subsidiaries in order to branch across state lines, Congress (at the urging of the Treasury Secretary) instead concluded that in order to achieve national treatment foreign banks needed to be permitted to establish direct branches in multiple states without incorporating a U.S. bank subsidiary, even though – at the level of the U.S. bank subsidiary – that would have made the structure and regulatory framework the same and would have provided a consistent platform for interstate branching regulation.

The Broader Implications

The U.S. national treatment principle, which has both benefitted and burdened foreign banks operating in the United States since the 1970s, has important practical and policy implications for all internationally active banks. How the principle is defined and applied in practice by the FRB is critically important, not only for FBOs (because of the direct consequences for their U.S.

operations), but also for all internationally active banks in view of the FRB’s leading role as an international bank supervisor and its role as the consolidated supervisor of many of the world’s largest banking organizations. National treatment historically has been a U.S. policy priority in part because it strengthens our government’s hand in trade negotiations where access to financial markets is at issue. And more broadly, U.S. national treatment for foreign banks helps promote U.S. banks seeking national treatment abroad.

This consequence becomes especially relevant as many jurisdictions, including ones with major financial centers, continue to consider their own structural approaches to the regulation of domestic and cross-border banking operations. And it leads to the question of how the FRB’s recent shift in application of the national treatment principle will inform other countries’ approaches.

Defining national treatment based on how U.S. regulations are applied to U.S. operations of foreign banks in isolation (without regard to their role as part of an FBO) arguably reflects the broader thrust of FRB policy developments in this area. A “Fortress America” approach involves a distinctly discounted reliance on parent bank and home country support and cross-border supervisory coordination, understandably reflecting the FRB’s experiences during the financial crisis and its outlook on how relevant actors are likely to behave in a future crisis. Thus, it may be that as other countries turn inward and adopt a more nationalist approach to banking and financial stability regulation, notwithstanding ongoing efforts to coordinate internationally, they will follow the FRB in redefining the application of national treatment, with potentially lasting changes to the organizational structure and efficiency of cross-border banking. ‘‘As other countries turn inward

and adopt a more nationalist approach to banking ... they will follow the FRB with potentially lasting changes to the efficiency of cross-border banking.



Faster Payments

TThe Automated Clearing House (ACH) system, which clears and settles the exchange of electronic transactions between participating depository institutions, processed nearly 22 billion transactions with a total value of $38.7 trillion in 2013. That is more than double the Gross Domestic Product of the American economy. It is more than 80 times the amount of money that the Treasury Department prints every year. And if you had $38.7 trillion, it would equate to enough one-dollar bills to fill more than one hundred Empire State Buildings. There can be no doubt that is an incredibly impressive achievement, which greatly benefits American society.

The ACH system is just one form of an electronic payment network; others include card networks and the emerging domain of faster payments. All combined, they equate to an enormous presence in the economy that improves life for consumers. By using the ACH system, for example, consumers can receive paychecks, get Social Security benefits, or pay mortgages. Indeed, a recent study by the Federal Deposit Insurance Corporation found that 80 percent of households with a bank account use some form of direct deposit.

Clearly, we all rely heavily on ACH and other electronic payment systems to conduct our daily lives and operate the businesses that power our economy. And, in general, these electronic payment systems work well because of the efforts of federal oversight and self-regulation by most financial institutions. But we believe there is room for improvement, and we are sure that most in the industry would concur. Specifically, we have three primary areas of concern: transparency, security, and access. Let me describe each of these in more detail.

by Richard Cordray, Director, Consumer Financial Protection Bureau

Protecting Consumers in a World of


Transparency

First, at the Consumer Financial Protection Bureau, we believe transparency can be improved within the electronic payments space to help consumers make more informed decisions and take greater control of their economic lives. When consumers make a deposit into their bank or credit union account, it is often difficult for them to know when the funds will be available. This is most true when consumers deposit a check. While NACHA (formerly the National Automated Clearing House Association) rules and ACH operator agreements clearly stipulate transmission and settlement requirements to participating depository institutions, consumers may know little or nothing about these requirements and the underlying cutoff times and settlement windows that dictate when their funds are

available for use. The same can be said for transferring money from one bank to another; consumers may be quite unclear when funds will be available. In the end, the rules and practices governing the availability of funds are quite complex. Even with the NACHA and ACH rules, internal policies and practices can differ from bank to bank; they can vary for different types of accounts, different types of deposits, and even when and where a deposit is made. The practices can even vary for different consumers within a single bank. The timeframes allowed by law are often quite long relative to the time it actually takes to clear the payment, leaving some consumers without access to needed funds.

Similarly, consumers may face uncertainty about when payments are debited from their accounts. Check payments, again, are generally the hardest to predict


since consumers have no way of knowing when the person to whom the check is written will deposit or cash the check. Nor do consumers know how long it will take for the institutions to clear the check. But debit card payments and other electronic payment transactions can also carry great uncertainty due to various factors, including merchant delays and transaction order manipulation. A consumer paying her mortgage electronically, for example, may not know if her mortgage payment will be subtracted from her account before her pay is direct deposited, let alone before her car payment or credit card payment is deducted.

For some, these uncertainties are of little consequence because they are able to maintain a healthy cushion of funds in their checking accounts. But many other consumers struggle to keep up with their expenses and have no such cushion. Not knowing when a payment will be credited or debited can cause significant harm to those with a bank account that can be precariously low on funds. Many, as they reach the end of a pay period, find themselves playing a high-stakes game of chance without even realizing they are at the gambling table. They are writing checks, paying bills online, or making purchases without knowing what will happen when the payments actually reach their accounts.

The results for these struggling consumers are a set of expenditures that they can ill afford – the high costs

of overdraft and non-sufficient funds (NSF) fees. We published a report in the summer of 2014 documenting how much consumers are paying because of these fees. In our study of accounts at a number of large depository institutions, we found that more than 30 percent of consumer accounts had at least one overdraft in the course of a year. We also found that about one quarter of those with at least one overdraft incurred more than ten overdrafts, and paid, on average, $380 in overdraft fees. In total, overdraft and NSF fees represent over half of all checking account fees.

Of course, not every overdraft is the result of consumer uncertainty. There are no doubt times when consumers make a conscious decision to use overdraft as a very expensive means of bridging the gap to the next paycheck. But the fact that the median size of transactions triggering an overdraft fee is just $24 for debit-card transactions – and the median amount by which the transaction overdraws the account is even less – suggests that for many consumers the costs may be as unanticipated as they are unwanted.

The Consumer Financial Protection Bureau is carefully studying whether regulatory changes are warranted to address these issues. But we cannot ignore that one of the root causes seems to lie in the lack of transparency when it comes to how deposits and payments are processed by and between financial institutions. We all need to work together to make this process better.

Security

Second, we see room for improvement when it comes to protecting consumers from the loss, theft, or mistreatment that may arise from payment security problems.

The ACH system, as it currently operates, depends on the routing and sharing of sensitive bank account details. While seemingly benign, this routine practice can be fraught for consumers. It can expose them to great risks, particularly if unscrupulous people or businesses are granted access to their hard-earned money.

‘‘Some banks and credit unions have developed screening mechanisms to detect abuse before they authorize charges.

Protecting Consumers in a World of Faster Payments


When bad actors take advantage of weaknesses in electronic payments systems, consumers can find themselves paying for charges they never authorized or paying more than the authorized amount. Sometimes, they can find their accounts subject to ongoing “fishing expeditions,” as repeated and expensive attempts are made to collect a payment.

Through the Consumer Financial Protection Bureau’s consumer response unit, we have heard heartbreaking stories of such abuses. One consumer from Texas contacted us with a complaint about the Hydra Group, an online payday lender that operated through a maze of corporations based in the U.S. and abroad. She told us that she went to an online lead generator for a short-term loan to cover rent and groceries after a period of unemployment. She said she contracted with a lender to get the loan she wanted, but then, to her surprise, Hydra, another lender with whom she had not entered into an agreement, also deposited money into her checking account and thereafter began debits without authorization. That chain of events turned into a two-year battle with the company, and eventually, with the debt collectors who followed in its wake.

In September, the Consumer Financial Protection Bureau filed a lawsuit against the Hydra Group. Our investigation found that it used information bought from online lead generators to access consumers’ checking accounts to illegally deposit payday loans and withdraw fees without consent – exactly what it did to that consumer from Texas. The Hydra Group then falsified loan documents to claim that the consumers had agreed to the phony online payday loans. It was a cash-grab scam and it quickly added up to more than $100 million worth of consumer harm. After we filed suit, a federal judge froze the company’s assets and appointed a receiver to oversee the business and put an end to the illegal practices. Importantly, the Hydra group had been running its transactions through the ACH system and exploited the ACH system’s reliance upon ODFI liability, due diligence, and self-monitoring.

While the Hydra Group’s actions were especially egregious, unfortunately we have all seen some online

lenders abusing the electronic payments system. J.P. Morgan Chase did some insightful research in 2014 and reported that return rates on ACH payments for credit cards, mortgage loans, and auto loans are about 1 percent, whereas return rates for payday loans are about 25 percent. In other words, one in four payment processing attempts for payday loans are returned because of various identifiable problems: for “non-sufficient funds,” as “unauthorized,” because of requests to “stop payment,” or for incorrect account information. That is a substantial source of irregularity and consumer harm.

A number of factors may contribute to this staggering return rate for payday loans. But one that seems to be particularly common and troublesome is that of sending an astounding number of debit attempts to collect on a single payment. We received a consumer complaint about a lender making nine separate collection attempts in a single day. When spread over a typical collection period, such practices could cost the consumer hundreds of dollars in bank fees and hundreds more in lender fees. In another complaint, a consumer with multiple loans from several online payday lenders was hit with 59 payment collection attempts through account debits over a two-month period. The consumer’s bank account was ultimately closed with $1,390 in bank fees. Surely the financial institutions that accept these unscrupulous lenders and their payment processors as clients need to do a better job of ensuring that they are treating consumers fairly.

More importantly, consumers expect their own bank or credit union to be on their side. They trust them to hold on to their money, and banks and credit unions need to be better about doing just that. Unfortunately, we know that all too often institutions cannot provide adequate protection – such as successful stop payments, notices of revoked authorization, and an effective block on repeated attempts to process payments from the same source – to help their customers avoid this sort of third-party account abuse because their efforts are thwarted. In other instances, consumers’ requests for assistance from their banks may fall on deaf ears or get denied – despite a framework of operating rules and regulations


that stipulate otherwise. One Maryland consumer told us that she signed up her husband for a free trial at her local gym. When she attempted to cancel after the introductory period, the gym still took automated payments from her bank account. She contacted her bank and told them the charges were not authorized. But the debits went on for several months, sending her account into the red and racking up fees. Despite repeated attempts to stop the payments, and despite assurances by a representative from her bank that they would be stopped, the debits and fees continued.

The Consumer Financial Protection Bureau wants to work with industry to protect consumers from getting stuck in such situations. Various federal laws, such as the Electronic Fund Transfer Act and the Truth in Lending Act, protect consumers as they make payments. NACHA also has its own laudable rules to protect consumers and merchants, but they are only as strong or as weak as the monitoring and enforcement regimes that support them. These rules need to be policed and enforced more rigorously if they are to have their intended effect of actually protecting consumers. Banks and payment system administrators have important roles to play; they need to be proactive both to preserve consumer trust and to protect their customer relationships. Consumers should not be subjected to unauthorized payments or fishing expeditions. And in situations where they are being victimized, consumers need to be able to reverse unauthorized charges or prevent unauthorized billings. Neither the CFPB, The Clearing House, NACHA, nor any financial institution should tolerate nefarious activities that harm consumers.

Recently, some banks and credit unions have developed screening mechanisms to detect abuse before they authorize charges. We applaud these efforts. Other good practices we have seen include making it easier for consumers to dispute illegitimate transactions, promptly re-crediting accounts, and refunding related fees when an improper transaction goes through. These are all steps in the right direction to ensuring an even better system, but more needs to be done. We must all take a flashlight to the murkier corners of the electronic payment systems, find out what is wrong, and make

adjustments. We must all be vigilant about preserving consumer protections. This is not just our job at the Consumer Financial Protection Bureau; it should be the work of every financial institution, operator, and system administrator as well.

Access

Our third and final concern is access, and we believe there is room for improvement here too. Let me explain.

The ACH system and other electronic payment systems are critical pieces of our financial ecosystem today. They make our modern lives much more convenient, from making automatic monthly car payments to swiping a card at the corner store to buy a cup of coffee.

However, a substantial number of consumers forgo electronic payment systems and the benefits they provide. According to the FDIC’s most recent study of the unbanked and under-banked, almost one in five consumers with incomes under $15,000 report having used a check casher, as do one in six consumers with incomes between $15,000 and $30,000. When these consumers receive checks, they typically fork over up to 3 percent of the face value to get immediate, no-recourse access to their money.

The FDIC study tells a similar story about the use of bill payment and other money-order services. For consumers living on the edge – and millions upon millions of Americans do so – expedited payments are often as important as expedited funds access if they are to avoid costly late fees and the like. To be able to pay quickly and without extreme inconvenience, these consumers often resort to money orders. Indeed, among those earning $15,000 or less, almost two out of five people report having used a money order service from a nonbank firm, which often costs more; one out of three who earn between $15,000 and $30,000 report having done so.

To be sure, many of those using check cashers or bill payers do not have a bank account. Some may be shut out



of the banking system because of troubles they have had with accounts in the past, and because of imprecision in the way that the banks have furnished information about those troubles. Others may have opted out of the banking system, and in doing so, may be inadvertently forgoing relationships with institutions that can help to build long-term savings and result in marketing offers to establish credit to meet future needs.

But even among those with a bank account, one out of ten report having used check-cashing services and one out of four report having used money-order services. These numbers suggest that some consumers are willing to pay for faster access to their paychecks and faster payment services − services that many financial institutions simply do not provide. In short, the current payment system does not seem to be meeting all the real-world needs of these consumers.

Making a Good System Even Better

We think it is reasonable to expect that the greatest economy in the history of the world, given the modern technology of today, would have an electronic payment system in which transactions are completely transparent, consumers have the utmost trust that their money is secure, every consumer can get their money back promptly and easily if a payment is erroneous or unauthorized, and all financial institutions give consumers access as quickly as possible to their hard-earned pay and deposits. This would make an already good system even better. It would restore trust. It would bring more people into the fold. And, it would simply be good business.

Recently, there have been much needed steps in the right direction. The Clearing House has announced exciting plans to build a real-time payment system. NACHA is now re-proposing same-day ACH services. And the Federal Reserve Banks have just published a set of strategies for speeding up U.S. payments.

As The Clearing House and others move forward into the world of faster and even real-time payments,

it is essential that the interests of consumers remain at the top of their minds. A faster payment system should include real-time access to information for consumers about the status of their accounts to enable them to make more informed payment decisions and avoid penalty fees. The PIN debit system has operated for years

without assessing consumer fees when an authorization is declined because of insufficient funds. We see no reason why this model cannot be readily imported into a faster payment system, rather than the model based on “bounced check” fees.

Faster payments must also be accompanied by robust consumer protections to address fraudulent or otherwise unauthorized transactions and erroneous debits. Money may be able to move at warp speed with today’s technology, but consumers cannot. They will still need time to review their accounts, identify unauthorized or erroneous transactions, and dispute them with their bank just as they do today with ACH and other electronic payments. The goal should be faster payments, not faster unfixable errors, and certainly not faster unrecoverable theft from people’s accounts.

Furthermore, faster payments should bring with them faster access to the funds that a consumer deposits. As that time is reduced, these rules and practices must keep pace so that consumers – rather than their banks – are the primary beneficiaries of faster clearing and

‘‘Let us think and work together to build an improved payment system that continues to enhance and be worthy of America’s powerful market economy that is the envy of the world.


settlement. Along those lines, we are pleased to see that NACHA’s current proposal for same day ACH payments includes provisions to ensure expedited availability of funds to accountholders.

And finally, a faster payment system should be accessible to all customers and not just to the most privileged. In the end, a faster payment system can be made to work well on all sides – for consumers as well as for financial institutions and their commercial clients. It can bring greater transparency and less need for people to go outside that system to obtain access to their funds and pay their bills. But we urge financial institutions to plan these advances not with an eye to the minimum of what today’s rules and regulations require, but by building in the kind of robust safeguards and features that consumers should be able to expect both now and in the future. There are two great reasons why financial institutions should be motivated to do that. First, all customers, and especially the customers that banks most want to keep – and the merchants who want to

transact with them – will gravitate to the systems and the institutions that give them the protections, services, and speed they want, and that they trust the most. If consumers have to go outside the banking system to get that speed, that service, that protection, and that trust, they surely will. Financial institutions simply must put themselves in position to outcompete the alternatives that are rapidly evolving in this space. Second, rising

consumer expectations have a natural tendency to ripen into laws and regulations, and it would be quite shortsighted to make the substantial investments in the payment system that the industry is now contemplating, only to fall short in the foreseeable future.

Clearly there are many great challenges here. Yet it is also important that The Clearing House, NACHA, and the Federal Reserve Banks move as quickly as they can with their efforts. Others around the world have built faster payment systems, and new avenues of competition are already opening up around alternative payment methods. Obviously building a faster payment system is an enormous project that will cost, in total, billions of dollars. But that will be true whether it happens now or in the near or distant future. We applaud The Clearing House for laying out its specific and ambitious plans to move quickly into the future here. Its leadership is essential to spur others to recognize the urgency of the need to upgrade a payment system that is in danger of being undermined or superseded by technological change.

At the Consumer Financial Protection Bureau, no matter what payment system consumers will be using, we expect them to be able to transact securely and to exercise control over their own money. Their money should be safe in the bank, safe in transit, and returned promptly if that safety is violated. We know that both the leadership and the rank and file at our financial institutions agree with these principles and work to make good on them every day. Of course, every one of us is a consumer ourselves and we all share that common perspective. So let us think and work together to build an improved payment system that continues to enhance and be worthy of America’s powerful market economy that is the envy of the world. ‘‘As The Clearing House and

others move forward into the world of faster and even real-time payments, it is essential that the interests of consumers remain at the top of their minds.



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TThe global trend toward real-time payments systems has accelerated dramatically over the past decade. Although Japan introduced a real-time system much earlier, in the 1970s, and Switzerland did in the 1980s, during the past ten years Brazil, Chile, China, Denmark, India, Mexico, Nigeria, Poland, Singapore, South Africa, Sweden, Turkey, and the United Kingdom have all made the shift. Australia, Norway, and Colombia are currently developing systems – and the United States is hot on their heels.

As systems move to real-time, many industry stakeholders fear increased fraud. The shift from batch to real-time processing is likely to make a payment system more attractive to fraudsters by allowing them to perpetrate fraud faster, but there are substantial ways to reduce fraud risk. Right now U.S. banks and other industry participants have a unique opportunity to thwart fraud by integrating multiple layers of security into the design of a new payment system.

Plans for Real-Time in the U.S.

The Federal Reserve Banks, in September 2013, published a consultation paper1 on the future of U.S. payments that examined gaps and opportunities in the current system and desired outcomes for the future. One of the desired outcomes

1 Payment System Improvement—Public Consultation Paper, https://fedpaymentsimprovement.org/wp-content/uploads/2013/09/Payment_System_Improvement-Public_Consultation_Paper.pdf

by Leo Lipis, Lipis Advisors

Preventing Fraud in Real-Time Payments

Modern Methods for the U.S.:


would constitute a major shift: a ubiquitous retail payment system that can deliver an electronic payment in near real-time to a beneficiary, without the need for the receiver’s bank account information. The paper elicited nearly 200 responses, and the Federal Reserve System has since been actively exploring how real-time payments can be implemented in the United States.

In October 2014, The Clearing House announced2 its intention to build a real-time payment system in the coming years. The potential benefits to consumers and businesses that TCH cited included convenience, data privacy, ease of use, cost savings, certainty of payment, and improved cash management. Despite the many legitimate concerns about real-time, the development of an infrastructure for near-instant electronic payments will soon become a reality in the United States.

The Extent of Fraud Today

One of the most pressing issues banks, system operators, and regulators need to address is how real-time processing affects fraud in the payment system. For perspective, we should first look at fraud in the current system. According to the 2013 Federal Reserve Payments Study,3 there were a combined 31.1 million unauthorized transactions in the United States in 2012 using cards, checks, and ACH/wire transfers, with a total value of over $6 billion. As electronic payment methods improve in speed and convenience, so will the speed at which money can be moved fraudulently. Thus, tackling the issue of fraud will become more important than ever.

Cards, Checks & ACH

Card transactions see the highest degree of fraud in this country. The 2013 Federal Reserve Payments Study

2 The Clearing House to Undertake a Multi-Year Effort to Design and Develop a Secure, Real-Time Payment System, https://www.theclearinghouse.org/press-room/in-the-news/2014/10/20141022-tch-to-develop-real-time-payments-system

3 The 2013 Federal Reserve Payments Study, https://www.frbservices.org/files/communications/pdf/research/2013_payments_study_summary.pdf

found 92 percent of fraudulent non-cash transactions were executed using cards in 2012, a number that dwarfs the three percent for checks and the five percent for ACH. Most card fraud comes from card-not-present transactions, which, in the study, had three times more incidents of fraud than card-present transactions.

Card-present fraud, including magnetic stripe skimming or cloning, is still a major issue in the U.S. market, but the way to mitigate this risk is clear. The United States is in the process of implementing EMV chip-and-pin technology at point-of-sale terminals by October 2015, when major card networks will shift liability for fraud to merchants if they do not comply with EMV standards. Chip-and-pin transactions are far more secure than magnetic stripe, and this change will help reduce card-present fraud. The widespread adoption of EMV standards in the European Union that began in the mid-2000s has led to a sharp decrease in domestic card payment fraud. Today, with nearly all European ATMs and POS terminals EMV-compliant, almost all card payment fraud that occurs with European-issued credit/debit cards occurs overseas in countries that have not yet adopted EMV standards.4

There are many reasons for the low level of fraud in ACH payments: originators are vetted more thoroughly; transaction authorization procedures for originators are generally stricter; push credit transactions (where the payer initiates an ACH payment) are less attractive to fraudsters, and these accounted for 38 percent of transactions in 2014 according to NACHA; and transactions are more easily traceable. Implementing a real-time payment system for electronic credits could eliminate much fraud, but strong fraud countermeasures need to be put in place to avoid the levels of fraud we see in card payments.

Lipis Advisors has had the privilege of examining the majority of real-time systems in existence and in development around the world. Our research looks at operational aspects of real-time payments such as settlement methods, posting times, data standards, and

4 Europol report, “Payment Card Fraud in the European Union.” 2012 https://www.europol.europa.eu/sites/default/files/publications/1public_full_20_sept.pdf


Modern Methods for the U.S.: Preventing Fraud in Real-Time Payments

ORIGINATOR

RECIPIENT

BANK B

1 4A 74B

75A

7

76

CLEARINGHOUSE

CENTRALBANK5B

BANK A 32

8

1. Payment order initiated by entering recipient mobile number and the originator authorizes payment.

2. Originator’s bank receives order, checks credentials and availability of funds.

3. Mobile number is matched with receiver’s account information in database.

4. Originator receives confirmation message with receiver’s full name (4a), must confirm within 10 seconds (4b), otherwise transaction is rejected.

5. Payment is submitted to clearing house for processing (5a) and checked for sufficient funds in Bank A’s settlement account at the central bank (5b).

6. Payment is output to Bank B and posted to recipient’s account.

7. Confirmation of transaction is sent to both originator and recipient.

8. Final settlement occurs during the next settlement cycle.

Real-Time Payment System Schematic


pricing, as well as value-added services such real-time remittances and mobile payments. We have examined in detail the fraud countermeasures in at least ten real-time systems. From this experience we have specific recommendations on optimal security measures for the forthcoming real-time system in this country.

Real-Time Payment Processes

A real-time payment is an interbank account-to-account payment posted and confirmed to the originating bank within 60 seconds, and often much faster (within 5-10 seconds). The distinction between posting and settlement times is key to understanding the process. Payments post in real-time, but the majority of real-time systems settle in net several times per day on the same day as posting.

The following schematic shows a generic process flow for real-time payments made with a mobile phone, applicable to online payments as well. (In systems that do not feature a proxy number database, payments initiation occurs without Step 3.)

Increasing Speed Without Sacrificing Security

As the speed of payments processing and posting increases, what should banks and clearing houses do to guarantee the same level of security that they do in a same-day or next-day environment – or even improve it?

The best way to prevent fraud in systems of any speed is by making payment initiation more secure. Multi-factor authentication – the use of two separate devices and channels – is the most effective way to do this. Many countries outside of the United States have instituted two-factor authentication to send a credit transfer through online banking. In addition to the user name and password required to log on to online banking (first factor), customers must also input a one-time security code in order to send a transaction (second factor). This code can be sent via a mobile phone, generated via a

token such as a key fob, issued via a hardened browser stored on a secured USB stick, or it can come from a paper-based slip with multiple one-time use codes. The central issue is that authentication takes place with a different device than for initiation.

Tokenization and Analytics

Real-time processing can transform the value proposition for mobile payments. Two of the most promising real-time use cases for mobile are point-of-sale applications and peer-to-peer products. Many consumers are uneasy about giving out their bank account details, but this concern can be alleviated by replacing the exchange of bank account information with a non-sensitive data element (token) that links to a customer’s bank account details, which remain concealed.

The token can either be a one-time use element that is generated at the moment of payment initiation or it can be a persistent proxy number such as a phone number or email address linked to a person’s bank account details via a secure database. In addition to the added security of not having to share one’s bank account details with another person or business, the use of proxy numbers also promotes ease of use since most people have not memorized their bank account details. Instituting a proxy number database does create an attractive honey pot for fraudsters, but securing it does not present more of a security challenge than current bank back-office infrastructure. More important, assuaging customer concerns helps drive adoption of real-time system technology and the products and services built on top of it.

There are a number of potential operating models the U.S. could pursue when developing a proxy number database for mobile payments. The U.K. has created a national universal database for all banks called Paym that is operated by its national clearing house, Vocalink, and stores proxy numbers for registered bank accounts in the country. Sweden has developed a service that individual banks can join, Swish, that enables customers of


participating banks to send and receive mobile payments in real-time. Denmark has opted for a competitive model with multiple proxy databases that bank customers have to sign up for individually. Given the diversity of the U.S. banking market, the Danish model seems like the best fit for this country, where the key issue will be ensuring the interoperability of multiple mobile platforms.

The use of data analytics is also essential for preventing fraud in a real-time environment. The onus for fraud detection is mostly on originating banks, but payment system operators can use analytics to run pattern and velocity checks. Operators performing fraud checks with analytics may even be able to see fraud that individual banks cannot, such as cases where a suspicious number of transactions are destined for the same receiver account, which indicates it may be a mule account.

Rule Changes and Bank Policies

When a payment system moves to real-time, changes to the operating rules can help control fraud. Prime examples are omitting direct debits from the real-time system and checking for a valid authorization before funds are transferred. Direct-debit rules are more complex than those for credit transfers, and direct debit refund rights are also more generous. Preventing the ability of customers to initiate a pull transaction in real-time (where the payee initiates an ACH payment) is a

best practice that has been adopted by every real-time system in existence today.

Banks that want to take extra steps to prevent fraud on credit transactions can also institute limits on payment values or volumes, or set thresholds to trigger a transaction review. These measures allows them to ignore smaller value payments that pose little risk of fraud and focus on higher value transactions or on transaction volumes to or from a specific bank account. When the Faster Payments system went live in the U.K., some large- and medium-sized banks lowered the daily maximum transaction value limits due to fraud concerns. One bank set a transaction limit as low as £6.00 at one point. These banks then bolstered their internal analytics and pattern recognition practices to further mitigate the fraud risk.

Best Practices for Industry Participants

Anti-fraud mechanisms – multi-factor authentication, tokenization, analytics, rule changes, and individual bank policies – ensure the overall security and stability of a real-time payments system, but their use differs by a bank’s role and by the status of a payment in the transaction chain. Depository financial institutions have the bulk of the responsibility when originating a transaction; payment system operators can contribute to fraud detection and security; and though depository financial institutions on the receiving end have very few mechanisms to detect or prevent fraud in credit transactions, they can play an important role in direct debits.

Originating Depository Financial Institutions

The easiest way to prevent fraud in a real-time environment is to stop fraudulent transactions at the point of initiation, and in a credit push payment environment, the ODFI is most likely to bear the loss in the event of fraud. ODFIs therefore have the greatest incentive to stop fraud and the highest probability


‘‘As electronic payment methods improve in speed and convenience, so will the speed at which money can be moved fraudulently.


of success. Measures start with account-opening procedures, secure practices for payments initiation follow, and analytics can then help, but to a lesser extent.

U.S. payment industry stakeholders should work together to determine whether the prevailing account-opening procedures are adequate to prevent fraudulent accounts. Some best practices from other countries would be impractical here, such as accessing a national fingerprint database to verify identity, as South African banks do. Denmark offers a more practical model to follow, banks there have built-in delays that prevent users from making payments for several days after opening an account. As this country transitions to a real-time system, banks should review what information a customer needs to provide in order to open a bank account and how long they need to wait before using it.

The most important thing an ODFI can do to prevent fraud is to institute multi-factor authentication for payment initiation. Having at least two layers of security means that even if a person’s login information is compromised or their computer is stolen, a fraudster would also have to have access to the device (mobile phone, fob, USB stick, paper) that contains a one-time code to initiate a payment.

ODFIs can use analytics, such as velocity checks and pattern recognition checks, to detect fraud that they otherwise would not notice. Analytics can also flag a suspicious number of new beneficiaries registered to an account, in which case an ODFI can then place a hold on payments from the account, review transactions, inform other banks and regulators, or reject the transactions outright. The use of analytics provides an extra barrier when fraudulent transactions are initiated.

Payment System Operators

In a real-time environment, the primary anti-fraud best practice for a payment system operator is to calculate the probability of a transaction being fraudulent (also known as scoring transactions), but then refer

suspect ones to banks for decision-making instead of blocking the transaction outright. This allows operators to capitalize on the fact that they can sometimes detect patterns that banks miss, such as a suspicious set of transactions originating from multiple ODFIs and headed for the same RDFI or receiver. However, very few payment system operators around the world actually employ such techniques, and the reasons are varied. Many do not have the financial strength to accept liability for fraud cases that may slip through, and many operators have expressed concerns that establishing fraud checks could reduce the incentive of banks to establish effective prevention mechanisms. Nevertheless, such checks are common among large card processors and should be included in any set of best practices.

Receiving Depository Financial Institutions

For credit transactions, there is little an RDFI can do to prevent fraud outside of the normal know-your-customer and anti-money laundering/counter-terrorist financing procedures. By the time a fraudulent transaction has reached the RDFI, it is unlikely that the receiving bank can employ techniques that have not already been used by the originating bank or system operator. For direct-debit transactions RDFIs can verify that an authorization is in place, maintain and check white- and black-lists, and help reverse unauthorized transactions. However, there is no large system in the world that processes direct debits in real-time, as the complexity of direct-debit processing and refund rights make real-time direct debits impractical and more vulnerable to fraud. Some countries have sped up direct-debit processing so that they clear and settle multiple times a day, but real-time direct debits do not yet exist in any significant volumes.

Start With Credits, Avoid Debits

When developing a real-time system, the best practice is to institute real-time for credit transfers only. A few countries (such as Switzerland) claim to offer real-time


debits, but these transactions are actually requests for real-time credit transfers, they are not true pull transactions. A payer can pre-authorize a push credit transaction to a payee, and the payee’s bank then has the authority to initiate this pre-authorized transaction. This method for real-time “debits” has proven to be secure in the countries that offer it, but they are not direct debits in the traditional sense.

There are good reasons why no real-time system in the world currently offers genuine pull direct debits. Many scheme rules require an RDFI to notify the ODFI (or the originator to notify the receiver) of a direct-debit authorization days before the transaction is settled. Direct debits can often require a notification period where a bank must inform its customer before money is drawn from their account, which can defeat the purpose of real-time. And almost all payment systems have lengthy return periods for disputed direct-debit transactions, which can discourage one-off direct debits and would likely produce skepticism from industry stakeholders were real-time direct debits under consideration.

It’s possible that real-time direct debits could be developed for a particular use case, but given the necessity of refund rights and the complexity of the fraud prevention they require, a system should only add real-time debits when the need justifies the marked increase in risk. The first country to do this will be blazing a new trail.

Striking a Balance

When the United States moves to real-time, banks should strongly consider allowing consumers to initiate real-time ACH transactions to any valid bank account. This would be a marked improvement from the current way most U.S. ODFIs treat bill payment, allowing ACH payments only to pre-registered beneficiaries. Most countries with real-time systems today automatically allow all bank customers to use the real-time system without any special registration requirements for either payer or payee. The ability should apply to all

ACH payments, whether real-time or same-day/next-day. There is no need to create institutional barriers to consumer and business use of the system.

Real-Time Security Demands Industry Participation

Many view real-time processing as essential to enabling the development of new products and services in demand by corporates and consumers. Banks and system operators can mitigate the related fraud risks by instituting multi-factor authentication for payments initiation, using tokenization to keep bank account information private, applying analytics to detect broad patterns of fraud, and limiting real-time processing to credits (push payments) only. Ensuring usability can be achieved by allowing customers to initiate real-time payments directly and by avoiding any kind of special registration process. By working together to institute these measures, industry stakeholders can ensure a fast, secure, and ubiquitous system for real-time payments that paves the way for future innovation and flexibility.



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ACybersecurity CollaborationRoutes to Stronger Defenses

As an industry, the financial sector outpaces other economic sectors in cybersecurity preparedness. Despite these efforts, however, cyber criminals still target bank networks, their executives, key employees with escalated privileges, and third parties with important connections to financial institutions. Criminals too often have ready access to sophisticated technology, enjoy the ability to organize and collaborate, benefit from a steady pipeline of talent, and generate enormous streams of illicit revenue with little chance of being caught. This “business model” needs to be disrupted. Foundational to the required change is improving collaboration between financial institutions and the United States government.

A vast and increasingly lucrative network of criminal organizations offers an array of cyber criminal services for hire. The network centers in Russia and many of its neighbors in eastern Europe, but extends into China, the Middle East, and virtually every corner of the globe. These organizations compete like other businesses, but they also collaborate, share ideas, and, like many other tech-based enterprises, innovate rapidly to develop new products and services. Malicious actors targeting financial institutions include: cyber criminals motivated by money, terrorist organizations with varied agendas, so-called “hacktivist” groups with political agendas, and even nation states bent on obtaining intellectual property or accomplishing a foreign policy objective. Banks must constantly adapt to the evolving threat environment, improving their agility, enhancing their capabilities and taking action on information shared by our partners in government.

by Jonathan Cedarbaum, Partner, WilmerHale and Sean Reilly, SVP & Associate General Counsel, The Clearing House


In response to these growing threats, financial institutions have dramatically increased their own investments in cybersecurity defensive measures. But truly effective cybersecurity will require further improvements by banks, increased efforts by the federal government to defend the financial sector against threats often originating overseas, and, above all, much more effective collaboration between the private sector and the government. As President Obama noted during the recent White House Cybersecurity Summit held at Stanford University, “There’s only one way to defend America from these cyber threats, and that is through government and industry working together, sharing appropriate information as true partners.” The private sector, the President acknowledged, “doesn’t always have the capabilities needed during a cyber attack, the situational awareness, or the ability to warn other companies in real time, or the capacity to coordinate

a response across companies and sectors. So we’re going to have to be smart and efficient and focus on what each sector does best, and then do it together.”

Yet legal, policy, and organizational impediments continue to hamper the ability of both financial institutions and the government to engage in the sort of effective cybersecurity efforts the president called for. This article examines a number of those impediments and offers some suggestions about how they can be reduced or overcome.

For example, many financial institutions have excellent information security programs in place, but many still need to improve their data security “hygiene.” There is no shortage of guides to cybersecurity health – perhaps most notably the federal cybersecurity standards issued


by the National Institute of Standards and Technology (NIST) in February 2014, known as the Cybersecurity Framework Version 1.0 – but really putting these guides into practice remains the key.

The government, too, needs to do more. Attacks on the financial sector are often intended as attacks on the United States. As the sophistication of cyber threat actors increases and more and more attacks emanate from abroad, the government needs to take a more active role in defending against and responding to these attacks. If that requires new legal authorities, we should candidly discuss what they should be.

Most crucially, financial firms and the government need to improve their collaboration. They need to improve their information-sharing practices with respect to cyber threats and responses. The Financial Sector Information Sharing and Analysis Center plays a critical role in the effort to make actionable cybersecurity intelligence available to financial firms. But much more still needs to be done.

Evolving Threats, Improved Internal Bank Defenses

Consider the evolving threat landscape …

Do you think of “blitzkrieg” as a type of warfare pioneered at the outset of World War II? Of course, it was that. But it is also the name international law enforcement authorities have given to a mass financial fraud campaign planned by a leading Russian cybercriminal who goes by the name of vorvZakone (“thief in law”).1

Do you think of “high rollers” as casino gamblers with deep pockets? Operation High Roller was another “highly sophisticated, global financial services fraud,” designed specifically “to siphon large amounts from high balance accounts,” sometimes more than $100,000 at a time.2

1 Ryan Sherstobitoff, McAfee Labs, Analyzing Project Blitzkrieg, A Credible Threat (2013).

2 Dave Marcus and Ryan Sherstobitoff, McAfee Labs and Guardian Analytics, Dissecting Operation High Roller 3 (2012).

These examples reflect what one of the leaders of the Secret Service’s cyber operations branch has called the “marked increase in the quality, quantity, and complexity of cyber crimes targeting private industry and critical infrastructure.”3

Leaders of the Secret Service’s cyber operations have also noted that “the increasing level of collaboration among cyber-criminals allows them to compartmentalize their operations, greatly increasing the sophistication of their criminal endeavors and allowing for the development of expert specialization.”4 As a result, “[i]llicit cyber crime marketplaces [that] allow criminals to buy, sell and trade malicious software, access to sensitive networks, spamming services, [and] hacking services” have grown at an alarming rate.5 Some of the more popular sites “boast…membership of approximately 80,000 users.”6 Many of these markets for “fraud-as-a-service” exist in the open internet, though behind password or other walls designed to allow access only to trusted users.7 Others exist in the so-called “deep web,” made up of “darknets,” online domains that use various techniques to remain outside the reach of search engines, thus “guarantee[ing] anonymous and untraceable access to Web content and anonymity for a site.”8

These illicit markets have physical bases around the world, but the most important groups are found

3 Statement of William Noonan, Deputy Special Agent in Charge, U.S. Secret Service, Criminal Investigative Division, Cyber Operations Branch, Before the Subcommittee on Financial Institutions and Consumer Credit of the House Committee on Financial Services 2 (Mar. 5, 2014). See also W. Gragido, Blackhatonomics: An Inside Look at the Economics of Cybercrime (2012)

4 Noonan Statement at 2.

5 Id.

6 Id.

7 For descriptions of some of the most popular “trojans,” i.e., malware designed to infiltrate networks via downloads and steal information, used against the financial industry and their evolution, see EMC, The Current State of Cybercrime 2013, at 3-5 (2013); Symantec, The State of Financial Trojans Version 1.02 (2013).

8 Vincenzo Ciancaglini, Marco Balduzi, Max Goncharov, and Robert McCardle, Trend Micro, Deepweb and Cyber Crime: It’s Not All About TOR 3 (2013).

Cybersecurity Collaboration: Routes to Stronger Defenses


‘‘in Russia. So extensive is the Russian cyber criminal industry that security researchers have uncovered extensive menus of goods and services offered, with fairly precise price ranges identified and competition like a mature technology market segment in the United States.9 “The most popular wares include different kinds of malware, Winlockers, Trojans, spammers, brute-forcing applications, crypters, and DDoS bots.”10 By one estimate, the Russian cybercrime industry, dominated by eight to twelve major criminal organizations, has revenues of roughly $2 billion per year, at least 40 percent of which comes from online banking fraud.11

Russia and its neighbors are hardly alone. China’s internet presence is the largest in the world, and China has a large and rapidly growing market for cyber criminal goods and services, particularly for those focused on mobile devices.12 Russia and its peripheries may be the leading incubator of cyber fraud activities, but China may be the biggest source of the broader array of malicious cyber activities overall.13

9 Max Goncharov, Trend Micro, Russian Underground 101 (2012). See also Group I-B, State and Trends of the “Russian” Digital Crime Market 2011 (2012) (with profiles of some of the leading figures), and Group I-B, Threat Intelligence Report 2012-2013 (2013).

10 Id. at 7.

11 Group I-B, State and Trends of the “Russian” Digital Crime Market 2011, at 5-6; Group I-B, Threat Intelligence Report 2012-2013, chs. 2 and 3. The Russian cyber criminal industry has become so well-developed that it has become a subject of study by sociologists and criminologists. See Thomas J. Holt and Eric Lampke, Exploring Stolen Data Markets Online: Products and Market Forces, 14 Global Crime 155-74 (2013); Thomas J. Holt, Examining the Forces Shaping Cybercrime Markets Online, 31 Social Science Computer Review 165-77 (2013); Marti Motoyama et al., An Analysis of Underground Forums, IMC’11, 71-79 (2011); Frank Wehinger, The Dark Net: Self-Regulation Dynamics of Illegal Online Markets for Identities and Related Services, 2011 European Intelligence and Security Informatics Conference; Bill Chu et al., Examining the Creation, Distribution and Function of Malware On-Line, report prepared for the U.S. Department of Justice (2010); Jason Franklin et al., An Inquiry into the Nature and Causes of the Wealth of Internet Miscreants, CCS ’07 (2007).

12 Lion Gu, Trend Micro, The Mobile Cybercriminal Underground in China (2014); Lion Gu, Trend Micro, Beyond Online Gaming Cybercrime: Revisiting the Chinese Underground Market (2013); Zhuge Jianwei, Gu Liang, and Duan Haixin, Investigating China’s Online Underground Economy (2012).

13 See, e.g., J.P. Morgan, Cybercrime: This Means War 2 (2013).

In total, the threats to banks in cyberspace have become more sophisticated, frequent, and costly. By one estimate, the annualized cost of cyber crime to the financial sector has more than doubled in the last five years.14

With all the focus on sophisticated cyber-threat actors, banks can lose sight of the crucial role of improved cybersecurity hygiene, that is, day-to-day data security risk management practices that can make a difference between an attack succeeding or failing. Some of the recent headline-worthy data breaches may have used points of entry that were accessible due to simple failings, such as inadequate training of employees or inadequate attention to the many routine vendors that may be given access to a company’s network. Among the hygiene measures banks should focus on are:

• Training both IT and non-IT personnel regularly and with a more hands-on approach

• Mapping points of entry carefully and reducing those network access points

• Prioritzing types of data and methods of defense within systems, not simply guarding the perimeter

14 Deloitte, Transforming Cybersecurity for the Financial Sector (2014).

The annual threat assessment by the Director of the Office of National Intelligence puts cybersecurity number one on the list of threats to U.S. security.


• Putting in place processes to oversee vendor and other third-party relationships throughout the relationship lifecycle, not merely at their outset

Financial institutions have more than a decade of experience under the data security and privacy requirements established by the Gramm-Leach-Bliley Act and its implementing regulations. The best practices set out in the NIST Cybersecurity Framework Version 1.0 in many respects match those earlier requirements, though they provide more detailed and up-to-date recommendations.15 The framework appears to go beyond existing requirements and regulatory expectations in a few areas by urging greater attention to:

• Efforts to recover from cybersecurity incidents, particularly the ability to maintain adequate capacity for ensuring the availability of data and systems

• Interrelations among companies in the financial sector and other critical infrastructure sectors

• Aggregating and correlating cybersecurity data from multiple sources

• Monitoring the physical environment, personnel activity, external service providers, mobile code, and unauthorized personnel, connections, devices, and software), not just IT systems

• Continuous and rapid adaptation of information security practices in light of rapidly changing technology, business, and threat environments

15 The Framework Version 1.0 is available here: http://www.nist.gov/cyberframework/upload/cybersecurity-framework-021214-final.pdf. For an initial analysis, go to http://www.wilmerhale.com/pages/publicationsandnewsdetail.aspx?NewsPubId=10737423378. For a description of how the Framework fits into the larger list of cybersecurity initiatives undertaken in response to President Obama’s February 2013 Executive Order on Critical Infrastructure Cybersecurity, see Cedarbaum and Schloss, Implementation of the Cybersecurity Executive Order and Presidential Policy Directive, Privacy and Security Law Reporter (Apr. 22, 2013), available at http://www.wilmerhale.com/uploadedFiles/WilmerHale_Shared_Content/Files/PDFs/cedarbaum-schloss-EOPPD-implementation.pdf.

Banks should be using the Framework to test and hone the effectiveness of their information security programs, both internally and in their dealings with vendors.16 The Cybersecurity and Critical Infrastructure Committee established by the FFIEC in late 2013 is expected to issue updated data security guidance soon.

More Vigorous Government Action

While banks do much of the work of cyber defense themselves; they cannot go it alone. The government needs to more as well. The recently released annual threat assessment by the Director of the Office of National Intelligence puts cybersecurity number one on the list of threats to U.S. security.17 Because so much of the critical infrastructure in the U.S. is in private hands, much of the threat to U.S. security stems from possible attacks on private targets, including the financial system. The government therefore needs to take a more active role in leading the response to these threats.

One threat that illustrates the point is botnets. “Botnet” is short for robot network. Botnets are networks of computers infected with sophisticated malware that enables them to be controlled remotely and used, whether individually or in combination, for various malicious ends. Often containing tens or hundreds of thousands of computers, sophisticated botnets can be used to launch distributed denial of service attacks that can cripple a company’s network. A number of major U.S. banks saw

16 See Office of the Comptroller of the Currency, Third Party Relationships: Risk Management Guidance, OCC Bulletin 2013-29 (Oct. 30, 2013), available at http://www.occ.gov/news-issuances/bulletins/2013/bulletin-2013-29.html; Consumer Financial Protection Bureau, Service Providers, CFPB Bulletin 2012-03 (Apr. 13, 2012), available at http://files.consumerfinance.gov/f/201204_cfpb_bulletin_service-providers.pdf; Letter from Roger Cole, Acting Director, Board of Governors of the Federal Reserve System to the Officer in Charge of Supervision, Appropriate Supervisory Staff at Each Federal Reserve Bank, and Banking Organizations Supervised by the Federal Reserve, FFIEC Information Security Booklet, SR 06-12 (July 28, 2006), available at http://www.federalreserve.gov/boarddocs/srletters/2006/SR0612.htm.

17 Worldwide Threat Assessment of the U.S. Intelligence Community, Statement for the Record of James R. Clapper, Director of National Intelligence, before the Senate Select Committee on Intelligence (Jan. 29, 2014) available at http://www.dni.gov/files/documents/Intelli-gence%20Reports/2014%20WWTA%20%20SFR_SSCI_29_Jan.pdf.



‘‘this kind of attack in the fall of 2012 by groups linked to the government of Iran. Botnets can also be used to steal financial credentials, as was the case with Game Over Zeus botnet, which the FBI believes was used to steal more than $100 million dollars from hundreds of financial institutions around the globe.

Both the U.S. government and some companies have gone to the court to seek orders enabling them to disable the servers used to power botnets. The Justice Department has also used some of its criminal authorities, such as the prohibitions on bank fraud and wire fraud, as bases for court orders designed to take down botnets. Although a number of these actions have achieved success, government agencies have been reluctant to leverage this tool. That may be partly due to uncertainty about the legal basis, but it also seems to stem from an overarching cyber strategy that focuses less on combating specific attacks and more on collecting information to identify the ultimate masterminds behind an attack. Government agencies should shift their cyber strategy to one that more closely resembles their strategy for old-fashioned bank robberies, which would give greater attention to preventing ... robberies, or quickly disrupting them when they are in progress.

A small step in this direction is included in the package of legislative proposals offered by the Obama Administration, which contains a proposal designed to improve the situation for government actions. It would amend the federal criminal code to make clear that violations of the principal federal anti-hacking statute, the Computer Fraud and Abuse Act, can serve as the premise for injunctive orders as long as at least 100 computers were affected in a one-year period. The proposal is designed to ease efforts by government agencies to “disrupt or shut down botnets” and combat attacks against bank networks.

Increased action by the U.S. government in other areas is also particularly important. The recent proposal by Chinese government to require all banks in China to reveal source code in the IT products they use provides a powerful current example.

On Dec. 26, 2014, the Chinese Banking Regulatory Commission (CBRC) issued draft regulations setting out

detailed security standards that IT products purchased by banks must meet in order to be considered “secure and controllable” for use by financial institutions in China. The draft regulations would apply to 68 categories of tech products, including servers, wireless routers, and ATMs. Source code powering operating systems, database software, and middleware must be registered with the CBRC to be considered “secure and controllable,” while only wireless routers that have approved encryption or virtual private networking (VPN) certificates may receive the designation. The draft regulations also specify what percentage of new purchases in each product category in 2015 must be considered “secure and controllable.” Every new PC purchased this year, must carry the designation.

The biggest concern arising from the regulations is that they could be used to provide the Chinese government with a backdoor into bank networks. Having the source code provides a roadmap for hacking the “secure and controllable” devices. In the worst case, those devices will have back doors for nefarious activities already embedded in them and in such a way that could result in the activities being undetectable by banks.

The regulations would initially focus on types of hardware and software where domestic suppliers already have a strong market position compared with their foreign rivals. On Jan. 28 2015, more than a dozen U.S. business groups sent a letter to senior Chinese officials protesting the draft regulations and seeking dialogue to have them

Government agencies should shift their cyber strategy to one that more closely resembles their strategy for old fashioned bank robberies, which prioritizes combating robberies before or when they occur.



reconsidered. Noting that these draft regulations targeting the financial sector follow a similar effort aimed at the telecom sector, the letter states: “Sovereign interest in a secure and development-friendly cyber economy is best served, in any country, by policies that encourage competition and customer choice, both of which necessitate openness to nonindigenous technologies, as well as close collaboration between industry and government in formal and informal public-private partnerships and other mechanisms.”

U.S. officials have also criticized the regulations. U.S. Trade Representative Michael Froman said in a Feb. 27, 2015 statement that the regulations “go directly against a series of China’s bilateral and multilateral trade commitments.” The rules, he pointed out, “would require technology transfer and use of domestic Chinese intellectual property as a pre-condition for market access – both of which China has committed not to do.” Froman pointed out that the rules are designed to protect and favor Chinese companies at the expense of foreign competitors, not to protect bank security, as advertised. “The administration is aggressively working to have China walk back from these troubling regulations,” he said in the statement.

Information-Sharing and Collaboration Obstacles

If banks and the government each need to do more on their own, the most important area for improved cybersecurity is more effective collaboration between financial institutions and the government. Information-sharing provides the clearest example where improved collaboration can make an enormous difference.

The sharing of cyber threat information both within the private sector and between the private sector and the government is crucial for several reasons:

• It enables more comprehensive, faster understanding of the threat environment, which is important for companies in developing defensive strategies and diagnoses following a breach

• The government’s national security and law enforcement resources have extensive international awareness, which banks may lack; this can be particularly important because foreign governments are involved in many cyber attacks and the biggest cyber-crime organizations are based overseas

• Because critical infrastructure is mostly in the private sector, the government needs information from the private sector in order to build up its understanding of the cyber threat environment and provide effective assistance

The rapid growth of a number of venues for information-sharing, most notably the Financial Services Information Sharing and Analysis Center (FS-ISAC), reflects both the private sector’s and the government’s recognition of the importance of cybersecurity information-sharing.

Yet, as Leo Taddeo, the special agent in charge of the FBI’s cyber and special operations division, acknowledged at a recent conference, financial institutions often have concerns that constrain their willingness to share information. Firms worry about liability risk, regulatory exposure, and reputational harm. They fear the information will be improperly disclosed or used for other purposes.

These concerns should not be overstated. Information-sharing efforts are increasing at an incredibly rapid pace. But those efforts could be made even more effective if certain remaining obstacles were removed. A few examples illustrate the point:

The Right to Financial Privacy Act strictly limits the ability of financial institutions to share customer records with the government absent a subpoena or other process and notification to affected customers.18 This can hinder information sharing by financial institutions with the FBI, the Secret Service, and other law enforcement agencies in the midst of an attack when, for example, government tools could be used to analyze a bank’s systems to identity

18 See 12 U.S.C. § 3414.


and/or neutralize the attack. A grand jury subpoena may be used as a vehicle to permit such an analysis of a bank’s systems, but securing a subpoena may cause delay when time is of the essence in the heat of an attack.

The Freedom of Information Act (FOIA) makes information shared with the government presumptively subject to public disclosure. Some shared information may be protected by an existing FOIA exemption. For example, the exception for “trade secrets and commercial or financial information” or for “records or information compiled for law enforcement purposes” may apply,19 but each of these exceptions has specific requirements and only applies when relatively narrow circumstances are present. In order to be confident that information shared with the government for cybersecurity purposes is protected, a bank would have to engage in a specific FOIA analysis of each piece of shared information before sharing. Given the operational need to share information with the government rapidly in cybersecurity investigations, it is impractical to require that banks to conduct this in-depth prior analysis.

Under the Department of Homeland Security’s Protected Critical Infrastructure Information program, financial institutions can share information with the federal government and receive certain protections, including protection against FOIA disclosure, loss of trade secret status, and privilege waiver.20 In order to be protected, however, the information must be shared with the government through DHS (or a handful of other authorized agencies, which don’t include critical agencies such as FBI, Secret Service and Treasury), and the information must be “accompanied by an express written statement” that makes rapid sharing, especially of digital information, difficult.21

One of the three main components of the cybersecurity legislative package announced by President Obama in January and the executive order he signed at the Stanford

19 5 U.S.C. §§ 552(b)(4), 552(b)(7).

20 6 U.S.C. § 133(a)(1).

21 Id. § 133(a).

Cybersecurity Summit are designed to encourage more effective and extensive cybersecurity information-sharing, in part by addressing the private sector concerns noted above. They represent important efforts to improve cybersecurity information-sharing.

The Obama Administration’s legislative proposal would provide both federal legal authorization that would preempt inconsistent state laws and liability protection for the sharing of cyber threat information. Those are very important steps in the right direction. But the proposal would appear to be limited in certain ways.

For instance, its protections would apply only to the sharing of “cyber threat indicators,” which would be defined to require the sharing company to have made “reasonable efforts . . . to remove information that can be used to identify specific persons reasonably believed to be unrelated to cyber threat.” The exact scope of information that “can be used to identify” individuals is not defined.

Also, authorization to share cyber threat information with the government “notwithstanding any other provision of law” would be given only for information shared with the National Cybersecurity and Communications Integration Center, a component of DHS, which in turn will be required to share the information with other agencies, including law enforcement and intelligence agencies. Authorization to share information directly with other federal agencies, including law enforcement agencies “for investigative purposes,” would be given only “consistent with [the agency’s] lawful authorities.” Thus, it is not clear, for example, that the proposal would remedy the RFPA issue described above.

Despite the limitations of this proposal, and the inherent legal and regulatory complexities of cyber threat information-sharing, moving forward on this front is imperative to financial stability and national security. The challenge for banks and government is staying nimble within a law- and regulation-abiding world, as the cyber thieves and other adversaries collude outside those boundaries.


TCH Q1 Risk Barometer: Banks Reducing Systemic Risk

Concerns about financial stability and build up of risk are at the forefront of regulatory agenda. Since the financial crisis a series of regulatory initiatives have been implemented or proposed with a specific goal of boosting stability of the banking sector, focusing on capital and liquidity as well the ability to withstand stressful events.

TCH Risk Barometer attempts to assess changes in risk among the largest banks in the U.S., analyzing their ability to absorb losses, the likelihood of experiencing losses, as well as the resiliency to stressful events. The first version of the barometer focuses on TCH member banks.

The barometer shows that over the last several years banks had become more resilient to stress, with reduction in “consumption” of capital under supervisory stress tests, with

capital consumption being the difference between the actual level of capital before the stress test and the minimum level of capital during a stress scenario.

Additionally, banks have been building capital cushions to absorb losses and improving the quality of portfolios, thus reducing the likelihood of losses. Since 2009-Q3, there is a significant increase in CET1 capital ratio as well as other measures of capital, an increase in riskless assets, and a reduction in non-performing loans and charge-offs.

The last indicator in the Barometer shows changes in systemic risk. Systemic risk is captured by SRISK which measures each bank’s contribution to capital shortfall in a hypothetical future crisis (Acharya, Engle,

and Richardson, “Capital Shortfall: A New Approach to Ranking and Regulating Systemic Risks,” American Economic Review, 2012, Vol. 102(3), pp. 59-64). Relative to 2009, there is a significant decline in systemic risk, with SRISK declining by 70%. The decline in systemic risk is consistent with other indicators in the Barometer that show a rapid accumulation of capital and improvements in the quality of the portfolios. Each “diamond” in the Barometer indicates a percentage change in the specific indicator between 2009-Q3 and 2014-Q2. We select 2009-Q3 as the starting point because of the relatively complete data for most banks and indicators. The bars around the diamonds indicate statistical uncertainty. Bars that cross the dashed “0%” vertical line suggest that the change in the indicator is not statistically different from zero while bars that are fully on either side of the “0%” line indicate statistically significant changes.

TCH αnalytics

CET1 / RWA

CET1 / total assets

Tier 1 capital / RWA

Tier 1 capital / total assets

Total capital / RWA

Total capital / total assets

Assets with zero risk weights

Non-performing loans

Charge-offs

Stressed Tier 1 risk-based capital

Stressed Risk-based capital

Stressed Tier 1 leverage

Stressed Tier 1 common

Systemic risk

-150% -100% -50% 0% 50% 100% 150%

Percent change relative to 2009-Q3

...better prepared to absorb losses,

y Significant increase in CET1 relative to risk-weighted assets and total assets

y Increase in Tier 1 capital and total capital

…less likely to experience losses,

y More than 50% increase in riskless assets

y Reduction in non-performing loans and charge-offs

…more resilient to stressful events,

y Capital “consumption” under supervisory stress scenarios is generally lower in 2014 relative to 2012

…and have less systemic footprint.

Considerable Reduction in Risk Among TCH Member Banks

1

2

3

4

Relative to 2009-Q3, member banks are…


The FDI Regulatory Restrictiveness Index measures statutory restrictions on foreign direct investment (FDI). The index for a specific country is constructed by taking into account four types of restrictions. These restrictions include: (1) foreign equity limitations; (2) screening or approval mechanisms; (3) restrictions on employment

of foreigners as key personnel; and (4) operational restrictions.

The Index is bounded between the values of zero and one, with zero representing the least restrictive value and one the most restrictive. As illustrated in the table below, United States is one of the most restrictive

countries in terms of total FDI and FDI in

financial services in 2013. It ranks 26th in

restrictiveness of FDI relating to financial

services and 27th in restrictiveness of

overall FDI, leaving the U.S. one of the more

restrictive countries when compared to its

European peers.

Country Financial services Total FDI Index Total FDI Ranking Financial Services Ranking

Japan 0 0.052 18 1Turkey 0 0.059 21 2Luxembourg 0.002 0.004 1 3Slovenia 0.002 0.007 3 4Netherlands 0.002 0.015 5 5Estonia 0.002 0.018 6 6Spain 0.002 0.021 8 7Denmark 0.002 0.033 12 8Slovak Republic 0.002 0.049 16 9Sweden 0.002 0.059 20 10Austria 0.002 0.106 28 11Poland 0.003 0.072 24 12Germany 0.005 0.023 9 13Hungary 0.005 0.029 10 14Ireland 0.009 0.043 14 15Czech Republic 0.01 0.01 4 16Finland 0.011 0.019 7 17Portugal 0.017 0.007 2 18Chile 0.017 0.057 19 19Italy 0.018 0.052 17 20Greece 0.02 0.032 11 21Belgium 0.024 0.04 13 22United Kingdom 0.024 0.061 22 23OECD - Average 0.035 0.068 23 24Israel 0.037 0.118 29 25United States 0.042 0.089 27 26Korea 0.05 0.135 31 27France 0.054 0.045 15 28Switzerland 0.067 0.083 25 29Norway 0.067 0.085 26 30Canada 0.077 0.173 33 31Iceland 0.119 0.167 32 32Australia 0.133 0.128 30 33Mexico 0.133 0.193 34 34New Zealand 0.233 0.24 35 35

Source: OECD FDI Regulatory Restrictiveness Index

FDI Regulatory Restrictiveness Index: 2013

Regulatory Restrictiveness Index: U.S. Ranks Below Most OECD Counties


1. The Federal Reserve Board, “Structure Data for the U.S. Offices of Foreign Banking Organizations,” Sept. 31, 2014. http://www.federalreserve.gov/releases/iba/201409/bytype.htm

2. TCH analysis of The Board of Governors of the Federal Reserve System data, “Assets and Liabilities of Commercial Banks in the United States - H.8.” http://www.federalreserve.gov/releases/H8/default.htm

3. Oliver Wyman, “Enhanced Prudential Standards For Foreign Banking Organizations: An Impact Assessment,” April 30, 2013, http://www.oliverwyman.com/content/dam/oliver-wyman/global/en/files/archive/2013/2013-04-30_OW_IHC_Impact_Analysis_-_Enhanced_Prudential_Standards.pdf

There are

433Offices of Foreign Banking Organizations in the US.1

In the US, FBO’s supported approximately

40%of debt origination and one third of equity origination in 2012.3

Since 2000, FBOs have represented

10%of bank credit outstanding in the United States on average.2

5 of the 10 largest broker-dealers in the US are subsidiaries of FBOs and significantly contribute to capital formation in US markets.3

0%

5%

10%

15%

20%

25%

2006 2007 2008 2009 2010 2011 2012 2013 2014

Since 2000

18%of all commercial and industrial loans in the United States have come from FBO’s.2

By the Numbers


1 5 0 Y E A R S O F D O I N G R I G H T

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Research Rundown provides a comprehensive overview of the most groundbreaking and noteworthy research on critical banking and payments issues and seeks to capture insights from academics, think tanks, and regulators that may well influence the design and implementation of the industry’s regulatory architecture.

ResearchRUNDOWN


Liquidity

Liquidity Creation: Superior Measure of Bank Output. The authors compare liquidity creation as a measure of bank output to traditional measures of bank output, namely total assets and gross total assets. They find that liquidity creation is a significant determinant of GDP per capita, while total assets per capita and gross total assets per capita are not. The reason may be, the authors posit, because in addition to assets, liquidity creation takes into account off-balance sheet activities, liabilities and capital.

Berger, Allen and John Sedunov (2015), “Bank Liquidity Creation and Real Economic Output,” University of South Carolina Darla Moore School of Business, Villanova University, (January).

Liquidity Shock Transmission. The authors analyze the effect a liquidity shock that is triggered by a credit rating downgrade. They find that a bank credit rating downgrade causes an immediate decline in access to non-core deposits and wholesale funding. This liquidity shock triggers a significant decline in domestic and foreign lending. To remedy this, the authors propose a centralized liquidity management system for top-rated banks. This will allow banks to direct liquidity where it is most needed within a banking group.

Karam, Philippe, Ouarda Merrouche, Moez Souissi and Rima Turk (2014), “The Transmission of Liquidity Shocks: The Role of Internal Capital Markets and Bank Funding Strategies,” IMF Working Paper, 14, 207, (November).

Capital

Optimal Level of Capital? The authors analyze bank capital regulation. They find that: (i) there is generally an optimal level of capital requirements; (ii) when bank leverage is high the economy is more responsive to shocks; and (iii) making capital requirements countercyclical is moderately stabilizing when the level of capital requirements is sufficiently high, but

destabilizing when the level of capital requirements is low. Therefore, regulators need to find a compromise between reducing the distortions associated with bank failure risk and constraining credit supply. The authors note that a compromise can be found at a capital ratio around 10.5%, which is above the Basel III levels, but below levels proposed by Admati and Hellwig.

Clerc, Laurent, Alexis Derviz, Caterina Mendicino, Stephane Moyen, Kalin Nikolov, Livio Stracca, Javier Suarez and Alexandros Vardoulakis (2014), “Capital Regulation in a Macroeconomic Model with Three Layers of Default,” Banque of France Working Paper, 533, (December).

Effect of Capital Requirements on Bank Business Models. The author examines whether capital requirements undermine liquidity creation by causing banks to reduce their deposits. The paper finds that a small rise in capital requirements can, in some cases, lead to a reduction in deposits, which can have high social costs. However, a more substantial rise in capital requirements reverses this effect and crowds in deposits.

Arping, Stefan (2014), “More Equity, Fewer Deposits? The Elusive Effect of Capital Requirements on Bank Debt,” University of Amsterdam Business School, (December).

Effects of Basel III on Capital, Credit, and International Competitiveness. The GAO measures the impact of Basel III capital requirements and the associated increased compliance costs on lending activity. The report finds that analysis of Q1 2014 data demonstrates that increased capital requirements and compliance costs will have a “modest” impact on lending activity, as most banks will not need to raise additional capital to meet the minimum requirements. Of the 10 officials the GAO interviewed from G-SIBs, three officials said that U.S. minimum capital ratios for Basel III “tend not to be the binding capital constraint,” and a majority of these bank officials said they expect the capital requirements to improve the resilience of the banking system. The report discussed issues of international competitiveness created by jurisdictional differences in

79BANKING PERSPECTIVE QUARTER 1 2015

the implementation of Basel III capital standards and noted that the competitive effect on internationally active banks is unclear at the present time.

Government Accountability Office (2014), “Bank Capital Reforms: Initial Effects of Basel III on Capital, Credit and International Competitiveness,” (November).

Leverage Ratio More Countercyclical than Other Capital Ratios. The authors investigate the behavior of the new Basel III leverage ratio and compare the new definition of the leverage ratio using the exposure measure as the denominator with alternative ratios (Tier 1/Total assets and capital-to-risk-weighted assets ratio). Using the financial statements of 109 international banks headquartered in 14 advanced economies for the period 1995-2012 the paper finds: (i) in normal times the leverage ratio based on the new exposure measure is significantly more countercyclical than other capital ratios; (ii) this result is driven by the inclusion of guarantees and other off-balance positions in the exposure measure; and (iii) all three capital ratios tend to be more pro-cyclical during the crisis period. Furthermore, the study shows that Tier 1 capital is weakly correlated with GDP and credit, namely banks do not accumulate capital in expansions and tend to smooth capital consumption in recessions.

Brei, Michael and Leonardo Gambacorta (2014), “The Leverage Ratio over the Cycle,” BIS Working Papers, 471, (November).

Risk

Survey Finds Sharpening Focus on Conduct Risk. In its second annual survey on how financial institutions manage their conduct risk, Thomson Reuters finds that although conduct risk continues to be a priority for regulators, 81% of financial institutions remain unclear about what it is and how to deal with it. The survey demonstrates that conduct risk has become one of the highest priorities for financial services firms. The changing regulatory environment has also been

identified as the biggest challenge when implementing conduct risk management.

Cowan, Michael, Stacey English and Susannah Hammond (2015), “Conduct Risk Report 2014/2015,” Thomson Reuters.

Hedging Credit Risk of Corporate Loans. The authors examine different factors that influence how banks manage the credit risk of their loan portfolios. Some factors include: borrowers credit quality, capital and liquidity requirements, existence of a prior relationship and reputational concerns. The paper finds that banks with capital and liquidity constraints are more likely to use credit risk transfer instruments (CRT). Furthermore, banks are more likely to use CRT instruments for transactional borrowers, and keep loans on their balance sheet if they have an ongoing relationship with a borrower.

Beyhaghi, Mehdi, Nadia Massoud and Anthony Saunders (2014), “Why and How Do Banks Lay Off Credit Risk? The Choice between Retention, Loan Sales and Credit Default Swaps,” University of Texas at San Antonio Department of Finance, Melbourne Business School University of Melbourne, New York University Stern School of Business, (December).

Internal Risk Models Inconsistent. The authors investigate whether there are systemic differences in banks’ reported risk metrics under the internal-ratings based approach. Using a data set of syndicated loan participants and their Basel II risk metrics, the authors find significant variations in how banks rate borrowers, namely some banks report risk metrics above the median of the syndicate and others report risk metrics below the median for the same syndicated loan. These findings indicate that some banks hold less capital for a given credit by reporting lower credit risk. Furthermore, the banks reporting less credit risk tend to be the least well capitalized.

Plosser, Matthew and João Santos (2014), “Banks’ Incentives and the Quality of Internal Risk Models,”


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Federal Reserve Bank of New York Staff Reports, 704, (December).

How Financial Institutions Efficiently Liquidate Large Positions. The author explores how large financial institutions efficiently liquidate large blocks of shares while balancing the need to liquidate with the cost of illiquidity. He finds that the liquidation strategy for an investor able to hedge market risk is the same as the liquidation strategy of a less risk-averse investor without a hedge. Additionally, the liquidation strategy for an investor able to hedge market risk is the same as for an investor facing higher price impact effects but without the ability to hedge market risk.

Monin, Phillip (2014), “Hedging Market Risk in Optimal Liquidation,” Office of Financial Research Working Paper, 14, 08, (November).

Systemic Risk

Systemic Risk in the European Banking Sector. The authors find empirical evidence of bank size, asset and income structure, loss and liquidity coverage, profitability and several macroeconomic conditions as drivers of systemic risk. Furthermore, the paper provides evidence that existing microprudential liquidity, capital and leverage rules are less effective and propose that policymakers consider new measures such as asset diversification to mitigate systemic risk.

Kleinow, Jacob and Tobias Nell (2015), “Determinants of Systemically Important Banks: The Case of Europe,” Freiberg University, (January).

Is Corporate Risk-Taking Excessive? The author posits that in this increasingly competitive and complex global economy, firms must take risks to innovate and create value for shareowners. The author examines how law should control risk-taking without impeding broader economic progress and focuses on the extent to which corporate risk-taking should be regarded as excessive. Schwarcz concludes that firm level liability may be

insufficient, and that managers should be subject to liability for engaging in excessive systemic risk-taking.

Schwarcz, Steven (2015), “Liability for Financial Failure: Corporate Risk-Taking and the Decline of Personal Blame,” Duke University, (January).

CoVaR and MES Not Reliable Measures of Systemic Risk. The authors use conditional value at risk (CoVaR) and marginal expected shortfall (MES) measures to determine individual financial institutions’ systemic risk. The authors construct hypothesis test statistics for CoVaR and MES that can be used to detect systemic risk at the institutional level, and apply it to daily stock returns data for over 3500 firms during 2006-07. Their tests identify almost 500 (1000) firms as systemically important supporting the conclusion that CoVaR and MES measures are incapable of reliably detecting a firm’s systemic risk potential.

Kupiec, Paul and Levent Guntay (2015), “Testing for Systemic Risk using Stock Returns,” American Enterprise Institute, Federal Deposit Insurance Corporation, (January).

Systemic Risk Theory Based on Uncertainty Aversion. The authors propose a new theory of systemic risk based on uncertainty aversion. The authors study an economy where uncertainty-averse investors hold a portfolio of risky assets. The authors write that these uncertainty-averse investors prefer to hold multiple uncertain assets in their portfolio. As a result, a shock to one asset class spreads to other asset classes creating contagion and uncertainty aversion becomes a source of systemic risk. Additionally, the paper finds that bank runs are associated with stock market crashes and flight to quality. Furthermore, the authors argue that increasing uncertainty makes the financial system more fragile and more prone to financial crises.

Dicks, David and Paolo Fulghieri (2014), “Uncertainty Aversion and Systemic Risk,” University of North Carolina Kenan-Flagler Business School, (November).


Macroprudential Regulation

The Interplay Between Microprudential and Macroprudential Regulation. The authors expose a fundamental tension between micro-prudential and macro-prudential regulation. The authors discuss how micro-prudential regulation aims to regulate risk taking at the individual level and that macro-prudential regulation seeks to contain systemic risk. They find that higher minimum capital requirements that reduce systemic risk and decrease the expected social cost of industry collapse may be preferable to ex-post lender-of-last-resort liquidity. Furthermore, the authors advise that rather than relying on market signals, regulators should generate their own data on aggregate risk which will allow them to intervene selectively.

Acharya, Viral and Anjan Thakor (2015), “The Dark Side of Liquidity Creation: Leverage and Systemic Risk,” European Corporate Governance Institute (ECGI) Finance Working Paper, 445, 2015, (January).

Tackling CCP Systemic Risk: Self-Funding Systemic Risk Charge for TBTF. The authors examine interactions of clearing members with a single central counterparty (CCP). The study finds that the clearing network tends to be dominated by a few clearing members with high total asset value, which raises systemic risk concerns because of the positive relation between bank size and systemic risk. This concentration may be reduced if clearing members are allowed to freely raise capital. Allowing banks to freely raise capital may induce an increase in the leverage ratio. A regulator then needs to control two systemic risk measures: (i) market concentration; and (ii) leverage ratios of individual members. To accomplish this, the authors propose a self-funding systemic risk charge ‒ a charge on size ‒ that would allow regulators to control market concentration without inducing clearing members to raise capital.

Capponi, Agostino, W. Allen Cheng and Sriram Rajan (2014), “Systemic Risk: The Dynamics under Central Clearing,” Columbia University, John Hopkins University, Office of Financial Research, (December).

Regulators’ Coordination Efforts in Implementing Dodd-Frank. The GAO finds that regulators coordinated on 34 of the 54 Dodd-Frank rulemakings it reviewed. For the Volcker Rule, interagency coordination led regulators to adopt a common rule and regulators voluntarily have continued coordination efforts during rule implementation. For swaps rulemakings, regulators coordinated domestically and internationally. However, such coordination did not always result in harmonized rules, and key differences among some rules have raised compliance and market efficiency concerns among market participants, industry associations, and foreign regulators.

Government Accountability Office (2014), “Dodd-Frank Regulations: Regulators’ Analytical and Coordination Efforts,” (December).

How Do Banks Respond to Changes in Regulatory Requirements. The author examines the constraints regulatory requirements impose on banks’ behavior and finds that if capital requirements are too low relative to the underlying credit risk in banks’ loan portfolios, increasing reserve requirements could lead to a higher number of bank failures. Additionally, higher capital regulatory requirements help reduce solvency problems but raise risk related to interconnectedness.

Chan-Lau, Jorge (2014), “Regulatory Requirements and Their Implications for Bank Solvency, Liquidity and Interconnectedness Risks: Insights from Agent-Based Model Simulations,” International Monetary Fund, (December).

Analyzing Macroprudential Policies that Prevent Systemic Instability. The authors develop a macroeconomic model which can be used to analyze macroprudential policies aimed at preventing systemic instability. They find that an episode of capital inflows and rapid credit expansion, triggered by low country interest rates, leads banks to decrease the rate of equity issuance, contributing to an increase in the probability of a crisis. The authors propose that policymakers use both countercyclical capital buffers and capital controls to lower the probability of financial crises.


Akinci, Ozge and Albert Queralto (2014), “Banks, Capital Flows and Financial Crises,” Board of Governors of the Federal Reserve System, International Finance Discussion Papers, 1121, (November).

Payments

How Should Retail Payment Systems Be Viewed by Regulators? The author focuses on the seven desirable benefits of the retail payment system: (i) finality and reversibility; (ii) universality (ability to use at point of sale and remotely); (iii) recordkeeping; (iv) liquidity (maximizing interest earning assets); (v) security and safety; (vi) financial inclusion and access; and (vii) fungibility and ease of use. While each retail payment system provides certain advantages, overall the analysis suggests that debit and credit cards represent the most desirable payment system for achieving the seven benefits set forth above.

Scott, Hal (2014), “The Importance of the Retail Payment System,” Harvard Law School, (December).

Structural Reform

Delinking Deposits and Lending Would Eliminate Financial Instability. The author argues for splitting the lending function from the safekeeping function in both traditional and shadow banking. In what the author calls a “Pure Reserve Banking regime”, safe banks would offer safekeeping and payment services, and nothing else. Loans would be a function solely of capital markets. The author notes that capital markets are now sufficiently developed both in terms of capital and technology such that it is possible to split the deposit and lending functions. The author argues that delinking deposits and lending would eliminate the root cause of financial market instability and enable safe banking that is not dependent upon an increasingly complex regulatory system.

Levitin, Adam (2015), “Safe Banking,” Georgetown University Law Center, (January).

The Case for a Break Up. The authors argue for the breakup of JPMorgan into a number of pieces by business line. Under their proposal, JPMorgan would be broken up into a “traditional” bank and an “institutional” bank. The benefits of a split would result in the pieces being worth more than the whole, in part because the pieces would in smaller buckets for the G-SIB surcharge. However several synergies of operating a consolidated institution would be lost by executing the split.

Ramsden, Richard, Conor Fitzgerald, Daniel Paris and Kevin Senet (2015), “New Capital Rules Reignite the JPM Breakup Debate,” Goldman Sachs Equity Research, (January).

Resolution

Multiple vs. Single Point of Entry. The authors argue that in order to make resolution of SIFIs a credible alternative to bailouts, EU financial firms need to move to a holding company structure so that the focus of resolution can be at the holding company level. This will allow regulators to replace the current European approach to resolution commonly referred to as the “Multiple Points of Entry” (“MPOE”) with the “Single Point of Entry” (“SPOE”) approach.

Gordon, Jeffrey and Wolf-Georg Ringe (2015), “Bank Resolution in Europe: the Unfinished Agenda of Structural Reform,” Chapter for Forthcoming European Banking Union, (Oxford University Press).

Monetary Policy

Impact of Monetary Policy Shocks on Financial Stability. The authors compare the effects of monetary policy surprises on the balance sheet growth of commercial banks and the shadow banking sector. The paper finds that monetary policy shocks tend to reduce the asset growth of commercial banks, but increases the asset growth of shadow banks and securitization activity.


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Nelson, Benjamin, Gabor Pinter and Konstantinos Theodoridis (2015), “Do contractionary monetary policy shocks expand shadow banking?” Bank of England, Working Paper, 521, (January).

Complexity

Banks Must Get Better at Managing Complexity. The Oliver Wyman report analyzes five important sources of complexity identified by their clients. They are: regulation; channel proliferation; systems fragmentation; product proliferation; and geographic expansion. Oliver Wyman proposes that banks adopt these five measures to reduce the cost of complexity: (i) use common metrics to develop self-knowledge of the financial institution and its customers; (ii) use advanced statistical analysis to make strategic decisions; (iii) automate or standardize core processes; (iv) delegate decision making to the subject matter experts who have the best information; and (v) build a strong corporate culture that supports consistent conduct standards.

Oliver Wyman (2015), “Managing Complexity: The state of the Financial Services Industry 2015.”

M&A Activity Continues. The authors analyze mergers and acquisitions in the financial institutions space. The memo finds that deals such as City National/RBC, BB&T/Susquehanna, and CIT/OneWest suggest that improved economic confidence and improved stability and visibility of the U.S. regulatory climate “will facilitate major mergers where the institutional size, strategic fit and perceived opportunity are just right.” The memo notes that regulatory factors impact, but do not impede, dealmaking.

Herlihy, Edward, Richard Kim, Lawrence Makow, Jeannemarie O’Brien, Nicholas Demmo, David Shapiro, Matthew Guest, Mark Veblen, Brandon Price and David Adlerstein (2015), “The M&A Landscape: Financial Institutions Rediscovering Themselves Amid Continued Regulatory Change, Intensifying Investor Activism and Technological Disruption,” Wachtell, Lipton, Rosen & Katz, (January).

Value of Large Banks

Acknowledging the Contribution of Finance to Society. The study outlines what finance academics can do to promote good finance. The author writes that finance academics should: (i) acknowledge that their view of the benefits of finance is inflated; (ii) they should be “the watchdogs of the financial industry, not its lapdogs;” (iii) get more involved in policy, not in politics; and (iv) do more from an educational point of view.

Zingales, Luigi (2015), “Does Finance Benefit Society?” Centre for Economic Policy, Discussion Papers, 10350, (January).

Accounting Standards

Reviewing Effects of Accounting Standards and Regulation on Bank Behavior. The paper reviews academic literature on the relationship between accounting and regulatory frameworks, and their effect on bank behavior. The review focuses on: (i) the fair value accounting; (ii) loan loss provisioning; (iii) application of prudential filters; and (iv) disclosure of accounting information.

Basel Committee on Banking Supervision (2015), “The interplay of accounting and regulation and its impact on bank behaviour: Literature review,” Bank for International Settlements, Working Paper, 28, (January).


Featured MomentsThe 2014 Clearing House Annual Conference, held Nov. 19-21, 2014 at the Pierre in New York, was attended by more than 600 of the banking industry’s most prominent policymakers, banking executives, and journalists. The event featured in-depth discussions on vital banking and payment topics as well as keynotes from many of the industry’s most influential leaders.

Timothy Geithner, former Secretary of the Treasury, addressed the audience during the Chairman’s Achievement Award Dinner, which honored H. Rodgin Cohen, Senior Chairman at Sullivan & Cromwell LLP.

Marcus Stanley, from Americans for Financial Reform, responding to a fellow panelist during the “Defining and Sustaining a Strong Bank Culture” panel on the first day of the Annual Conference.

The 2014 Chairman’s Achievement Award honored H. Rodgin Cohen, Senior Chairman at Sullivan & Cromwell LLP. Previous honorees include Michael Bloomberg (2013), former New York City Mayor and founder of Bloomberg LP, and Donald Kohn (2012), former Vice Chairman of The Federal Reserve System.

Following a full day of conferencing, Annual Conference attendees network during dinner.

The Federal Reserve’s Daniel Tarullo delivering his keynote presentation at the annual conference during breakfast on Thursday, Nov. 20.

Fellow panelists listen to James J. McAndrews, from the Federal Reserve Bank of New York, during the panel session “Measuring the Tradeoffs: Assessing the Relationship Between Macroprudential Regulation and Macroeconomic Performance.” Also pictured (Left to Right): David Wessel, The Brookings Institution; Andrew W. Lo, MIT Sloan; McAndrews; Laurence Meyer, Macroeconomic Advisers; and Michael Zeltkevic, Oliver Wyman.


Attendees filled the main ballroom during the Annual Conference to hear keynote speaker Anshu Jain from Deutsche Bank.

Richard Cordray from the Consumer Financial Protection Bureau delivering his keynote presentation during the lunch session on Thursday, Nov. 20.

Deutsche Bank’s Anshu Jain speaking during his keynote presentation on Thursday morning, Nov. 20.

BB&T Corporation’s Kelly King (left), and and Richard Davis of U.S. Bancorp, listen to Michael Corbat, from Citigroup, during The Chairman’s Panel: Strategic Views on the Evolution of the Banking Industry.

Deutsche Bank’s Jacques Brand gestures while he speaks during The Chairman’s Panel: Strategic Views on the Evolution of the Banking Industry. Richard Davis from U.S. Bancorp listens intently.


P.W. (Bill) Parker from U.S. Bancorp makes his point during the Risk Management Roundtable: New Paradigms in the Management and Regulation of Risk Panel.

The Clearing House Association and Payments Company’s James Aramanda delivers his welcoming remarks at the Third Annual Chairman’s Achievement Award Dinner.

The 2014 Chairman’s Achievement Award recipient, H. Rodgin Cohen of Sullivan & Cromwell LLP, delivers his acceptance remarks during the Chairman’s Achievement Award dinner.

The Honorable John E. Sununu , the former U.S. Senator, speaking during the Congressional Outlook Panel Breakfast Discussion, co-sponsored with the Bipartisan Policy Center. The Honorable George Mitchell (center), former U.S. Senate Majority Leader and Jason S. Grumet, President, Bipartisan Policy Center listen in.

Panelists share their views during the Defining and Sustaining a Strong Bank Culture panel. Participants include: Thomas C. Baxter, Federal Reserve Bank of New York; Eugene Ludwig, Promontory Financial Group; Gary G. Lynch, Bank of America; Paul Saltzman, TCH; Marcus Stanley, Americans for Financial Reform; Bill Woodley, Deutsche Bank NA; and moderator Matthew Bishop, The Economist.


Adam Farkas from the European Banking Authority speaks to the audience during the panel session: Trends in Bank Structural Reform: Considering the Implications for Financial Stability and Markets Panel.

Comptroller of the Currency Thomas Curry delivers his Keynote address during the luncheon session on the final day of The Clearing House Annual Conference, Friday, Nov. 21.

During a break at the conference, an attendee takes a selfie with The Honorable George Mitchell, former U.S. Senate Majority Leader.

H. Rodgin Cohen of Sullivan & Cromwell LLP posing with his 2014 Chairman’s Achievement Award.

Throughout the annual conference, attendees interacted with keynote speakers and panelists during informative question and answer sessions, as well as during networking breaks and receptions.


Paul Saltzman, President of The Clearing House Association and EVP & General Counsel of The Clearing House Payments Company, greeted the audience and introduced the featured speaker, Robert Engle, in TCH’s midtown offices.

Robert Engle, Nobel Laureate and Director of the NYU Stern Volatility Institute, shared his thoughts on systemic risk at the lecture.

TCH-NYU Gallatin Lecture Series. On Friday, February 6, The Clearing House and NYU Stern School of Business kicked off the quarterly Gallatin Lecture Series on Banking. At the first lecture Robert Engle, Nobel Laureate and Director of the NYU Stern Volatility Institute, presented his research findings on systemic risk to a full audience at The Clearing House’s offices in New York.


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In the Vault

This plaque lists the member banks in 1896 and was in the lobby of The Clearing House building on 77 Cedar Street in New York when the building was dedicated. When the building was built, there were 66 banks in The Clearing house, up from 52 banks when the association was formed in 1853. Each bank was assigned a number when it joined The Clearing House, starting with No. 1. The numbers were used on their notes, drafts and checks to speed processing. As seen in the photo, some numbers are missing (e.g. 5, 9, 11, 22, 24). With mergers, it was customary for the new bank entity to assume the lower number. Twenty-six, or exactly half, of the original banks ended up merging with other members.


Bank of AmericaBank of the WestBarclaysBB&TBNY MellonCapital OneCitiCitizensComericaDeutsche BankFifth ThirdHSBCJPMorgan ChaseKeyBankM&TPNCSantanderState StreetSunTrustTD BankUBSUnion BankU.S. BankWells Fargo

Celebrating more than 160 years of leadership, collaboration and innovation.For more than 160 years, The Clearing House and its Owner Banks have together addressed the most critical issues facing the banking industry and created innovative solutions to common problems. And our accomplishments are many—from helping shape banking policy and regulation to the creation and operation of safe and sound payment systems.

The legacy of working together is a framework that will provide the banking industry with great new possibilities and success in the future.

Join Us for the Industry’s LeadingBanking and Payments Conference.

NOVEMBER 1618, 2015The Waldorf Astoria, New York City

www.tchannualconference.com

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