Global banking, a model promoted for more than 30 years byfinancial conglomerates cobbled together through cross-bordermergers, is colliding with the post-crisis reality of stricternational regulation.

Daniel K. Tarullo, the Federal Reserve governor responsible forbank supervision, announced plans last week to impose the samecapital and liquidity requirements on the U.S. operations offoreign lenders as on domestic companies. The U.K. and Switzerlandalso have proposed banking and capital rules designed to protecttheir national interests.

Regulators want to curtail risks exposed after global banks suchas New York-based Citigroup Inc., Edinburgh-based Royal Bank ofScotland Group Plc and Zurich-based UBS AG took bailouts in thebiggest financial crisis since the Great Depression. Forcinglenders to dedicate capital and liquidity to multiple localsubsidiaries, rather than a single parent, may undermine thebusiness logic of a multinational structure.

“Being big and spread out all over the world isn't what it usedto be,” said Mayra Rodriguez Valladares, managing principal at NewYork-based MRV Associates, which trains bank examiners andexecutives at financial firms. “You'll see global banks jettisondivisions abroad and at home.”

UBS, Citigroup and RBS are among banks already doing just that,reversing decades of global expansion. UBS said in October that itplans to cut about 10,000 jobs and retreat from most fixed-incometrading after Switzerland set capital rules for its biggest lendersthat are almost double international minimums agreed to by theBasel Committee on Banking Supervision.

Citigroup and Bank of America Corp., the two U.S. lenders thatreceived the most aid during the financial crisis, have beenselling foreign operations and scaling back businesses. RBS,majority owned by the British government since being bailed out in2008, said it will close or sell its cash-equities,mergers-advisory and equity-capital-markets divisions.

The Fed's plan is part of a trend by national regulators sincethe crisis to ensure they can protect local depositors andcreditors of global financial institutions in the event of afailure. Even organizations such as the International Monetary Fundand the Basel committee, which have sought to foster globalfinance, have had to adapt their approaches or have been overruledby national and regional interests.

“Globalization of financial markets took us decades to build, itdoesn't look like it's going to take us decades to reverse thetrend, does it?” Charles Dallara, managing director of theInstitute of International Finance, which represents more than 450financial institutions, said at a meeting with journalists in NewYork the day after Tarullo's speech.

Switzerland, U.K.

Switzerland, whose banking system is five times the size of thenation's economy, proposed in 2010 to give priority to the domesticunits of its two largest lenders if they fail, indicating thatoverseas businesses might be left on their own. In the U.K., wherebanks' assets are also five times gross domestic product,regulators have said they plan to require lenders based in Britainto insulate domestic consumer-banking businesses frominvestment-banking and foreign operations.

“The likelihood that some home-country governments ofsignificant international firms will backstop their banks' foreignoperations in a crisis appears to have diminished,” Tarullo said onNov. 28 at Yale University in New Haven, Connecticut. “It alsoappears that constraints have been placed on the ability of thehome offices of some large international banks to provide supportto their foreign operations.”

Banks with large trading operations in the U.S., such asBarclays Plc, Credit Suisse Group AG and Deutsche Bank AG, probablywould be subject to the Fed's proposed requirements. Tarullo's planfollows moves by Frankfurt-based Deutsche Bank and London-basedBarclays to discard their status as U.S. bank holding companies,thereby evading local capital rules.

The role that foreign banks play in the U.S. has changed inrecent years. Through the 1990s, most borrowed from their parentcompanies to lend in the U.S. and had excess cash reserves to meetlocal requirements. The trend reversed early last decade, whenforeign firms started borrowing in the U.S. to lend overseas. Theirtrading in the U.S. surged to 50 percent of assets in 2011 from 13percent in 1995, Tarullo said.

Meeting multiple local requirements could mean global banks willhave to maintain more capital than currently dictated by their homecountries or international capital minimums established by Basel,according to Kim Olson, a principal at Deloitte & Touche LLP inNew York and a former bank supervisor.

Banking Balkanization

“This new standard is going to be very costly for foreignbanks,” Olson said. “Some will have to raise additional capitaljust to comply with U.S. rules. Moving it around from the parentcompany won't be enough because they'll discover they need morethan what Basel requires overall.”

Jean-Yves Fillion, the New York-based chief executive officer ofBNP Paribas SA's North American corporate and investment bank, said“trends toward Balkanization” make it harder to be a globalfirm.

“Is the cost of doing business in three or four continents goingto go higher?” said Fillion, whose Paris-based bank is the largestin France. “Absolutely.”

The U.K.'s Financial Services Authority published a consultationpaper in September that proposes requiring foreign bank branches inthe U.K. be organized as subsidiaries under British regulation ifthe home country has rules giving local depositors priority when alender becomes insolvent. The move, known as subsidiarization, wasa response to banking regulations in the U.S. and other nationsproviding such preferences.

“For a lot of these banks, business outside of the U.S. isconducted from a booking center, which is their London branch,”said Azad Ali, a financial-regulation attorney at Shearman &Sterling LLP in London. “These London branches are not subject tofull-scale U.K. regulatory supervision, it's shared between theU.K. and the U.S., so I think the way things are developing it isleaning toward subsidiarization.”

Lenders also have to contend with efforts by countries fromBrazil to the Philippines that have sought to manage capitalinflows inflating their currencies and threatening to create assetbubbles. Brazil, blaming the U.S. for sparking a global “currencywar” by keeping interest rates near zero, last year imposed a 6percent tax on firms that borrowed overseas in an attempt to reducecapital inflows that were causing a jump in the real. Brazilstarted rolling back the curbs in June.

Organizations such as the IMF have fostered the global bankingsystem by encouraging the elimination of exchange-rate restrictionsthat hindered trade. This week, the organization reversed itshistoric support for unrestricted flows of money across borders,saying it would favor the use of capital controls in certaincircumstances.

Protecting Taxpayers

The failure or near-failure of banks in nations such as theU.S., U.K. and Switzerland, as well as smaller countries such asIceland and Ireland, taught regulators that companies once seen asa source of national pride can lead to hand-wringing over how toprotect taxpayers.

“For the foreseeable future, then, our regulatory system mustrecognize that while internationally active banks live globally,they may well die locally,” Tarullo said.

When Lehman Brothers Holdings Inc. collapsed in 2008, Europeancreditors alleged that $8 billion of cash had been transferred tothe firm's New York headquarters days before the bankruptcy. WhenIceland's banks failed that same year, the government agreed to paylocal customers while leaving British and Dutch depositors tryingto recoup more than $5 billion.

“When the system blows up, every country ring-fences the assetsand liabilities in their jurisdiction anyway,” said Sheila Bair, aformer chairman of the Federal Deposit Insurance Corp. who helpedstabilize the U.S. financial system. “The Fed's move is in a waydoing that ring-fencing structurally.”

Bank managements probably will fight the moves. Ernest Patrikis,a former Fed official who's now a partner at White & Case LLPin New York, said he remembers doing just that when he served asgeneral counsel of American International Group Inc. before thecrisis. Two years after Patrikis left in 2006, AIG, once theworld's biggest insurer, was bailed out by the Fed.

“When I worked for AIG, we fought countries trying to forcesubsidiary structure on us,” Patrikis said. “Capital gets stuck ineach country when you do that. You can't move it around easily.Liquidity is even harsher. If the local unit has to abide byliquidity rules, it can only take a limited portion of the funds itraises in the U.S. outside.”

Empirical Evidence

Shearman & Sterling's Ali said that such structures probablywill be favored by regulators, who are warier of the risks posed bybranches not under local oversight.

“It depends upon how strongly the banks can demonstrate that ifsubsidiarization was forced upon them that their business modelwould be decimated and they would not be able to conduct the sameamount of business and there would be an adverse consequence uponthe markets or the economy and the provision of credit to theeconomy,” he said. “That's an argument that needs to be backed upby empirical evidence.”

Research has shown that stricter capital requirements can helpbanks by giving creditors and customers more confidence in theirstability, Ali said.

Ali's own firm published a Nov. 29 warning that the Fed's plancould lead to “significantly increased costs of doing U.S. businessand threatening the attractiveness of the U.S. dollar as a reservecurrency.” Lawyers at Davis Polk & Wardwell LLP in New Yorkwrote in a Dec. 2 memo that it could lead to “higher unemployment,lower output and more political instability.”

The British Empire and the gold standard supported an earlierversion of global finance that ended with World War II, saidMargaret Tahyar, a partner at Davis Polk who specializes inadvising on international transactions and regulation.

“We don't want to go back to national silos like post-World WarII,” Tahyar said. “But there was, in recent years, over-enthusiasmfor global finance without having thought through the institutionalstructures. So faith in that has been shaken.”

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