Euro banks spend billions to get US units fit for Fed

Bloomberg

Deutsche Bank AG, Barclays Plc and 11 other foreign banks have spent several billion dollars in the past three years complying with a new Federal Reserve rule that will trap capital in the US and boost costs.
Legal, technology and other compliance expenses totaled from US$100 million to as much as US$500 million at some of the biggest firms affected, according to five people with direct knowledge of the matter. They provided the data on the condition their companies’ individual costs wouldn’t be disclosed.
The rule, which takes effect July 1, requires foreign banks whose US assets exceed US$50 billion to create umbrella legal structures for their local operations and take part in the Fed’s annual stress tests. The 10 largest banks affected had average operating expenses of US$32billion last year, and a US$500 million tab would increase that by less than 2 percent. Still, three of the firms reported losses last year, and the added costs will make it more difficult to cope with challenges including the U.K. vote to leave the European Union as well as Europe’s lagging economy, negative interest rates and legacy bad loans. “That’s a lot of money for each bank, particularly in the current environment when they’re having difficulty making money,” said Karen Shaw Petrou, a managing partner at Washington-based research firm Federal Financial Analytics. “Banks have been spending lots more on compliance in recent years as regulations pile up on them. This takes money away from other tasks like entering new businesses.”

Stress Tests
The Fed introduced the standard in 2012, saying it would help make U.S. units of foreign banks safer even if their parents ran into trouble back home. It was designed to prevent a repeat of what happened during the financial crisis in 2008, when the Fed provided US$538 billion of emergency loans to European banks with operations in the US. Other European giants required to set up holding companies are Credit Suisse Group AG, BNP Paribas SA, UBS Group AG, Societe Generale SA and HSBC Holdings Plc. Mitsubishi UFJ Financial Group Inc. and Royal Bank of Canada are among the four non-European firms in the group.
Each consolidated US entity — called an Intermediate Holding Company, or IHC, because it’s positioned between a parent and its subsidiaries — has to abide by the same capital and liquidity rules domestic institutions face. That’s forced some of them to increase capital levels at their US businesses, which is typically accomplished by converting some existing intra-group loans into equity. No cash gets moved— all that changes is the US unit’s balance of debt and equity.

Capital Trapped
“Capital and liquidity being trapped here is a huge issue for our members as they comply with this new rule,” said Sally Miller, head of the Institute of International Bankers, a group that represents almost 100 banks with headquarters outside the US “That’s why you’ve seen many banks shrinking their US operations in recent years.”
Foreign banks whose assets were just above the US$50 billion asset threshold have been taking steps to get smaller so they won’t have to comply with the rule’s harshest elements.

Global Strategy
Some of their bigger competitors are getting smaller as well, though those moves have mostly been the result of global restructuring strategies aimed at refocusing on the most lucrative businesses, not the Fed rule.
“Our investment-banking business is smaller, like others, because of decisions we all took at the global level, exiting some business lines,” said Joe McGrath, co-head of banking at Barclays and the newly appointed chief executive officer of the firm’s IHC. “We’ve grown our U.S. credit-card business, and the investment bank here is still a very important, profitable and core operation for us. These new requirements haven’t
fundamentally changed our strategy.”
Gearing up for stress tests, which U.S. banks have been facing since 2009, accounts for much of the new IHC costs. Banks are asked to calculate potential losses on hypothetical doomsday scenarios and show they can weather them without going bust. JPMorgan Chase & Co., the biggest U.S. bank by assets, has said it has 500 employees dedicated to the test. Bank of America Corp. and Citigroup Inc. have said they spent more than $100 million each to improve their reporting capabilities after failing the tests in previous years.
Mock Test
Some U.S. units of foreign lenders have already been subjected to the stress tests because of their size, and a few have failed in recent years, including one of Deutsche Bank’s subsidiaries. With the new rule, the 13 firms’ entire U.S. operations will be included in the process. The Fed will conduct a mock test on the IHCs next year and a real one in 2018. Should they fail, restrictions kick in on distributing dividends to the parent company. The Fed will announce results of the current round on Wednesday.
Four banks won a reprieve this month on another regulatory hurdle because of the money and effort they’ve poured into forming IHCs. Barclays, Credit Suisse, Deutsche Bank and UBS were given an extra year to submit updates to their resolution plans, the blueprints that big banks must draft for dealing with their failure in a crisis.
One way to optimize capital is to rearrange where business gets booked. The biggest foreign banks active in the U.S. conduct their business mostly through subsidiaries registered there. Some business is carried out through the off-shore branch, typically located in New York. The Fed rule exempts those outlets from the capital calculation. As a result, foreign bank branch assets have more than doubled in some cases since 2012, according to Fed data.
The new rule isn’t all bad news for foreign firms. For one thing, it created a large barrier to entry for the world’s largest and deepest financial market. It’s also helped identify costs and benefits of each business line more clearly, helping firms streamline.
“We now understand the businesses within the entity at a more granular level,” said Bill Woodley, CEO of Deutsche Bank’s IHC. “We were worried that this rule was creating an uneven playing field versus our U.S. competitors, but we’ve also come to see some of the virtues since then.”