The Treacherous Landscape For Foreign G-Sibs The IHC Framework And Financial Stability

Abstract

In 2010, the Dodd-Frank Wall Street Reform and Con- sumer Protection Act restructured the regulatory regime for fi- nancial institutions in the United States by mandating corpo- rate governance reforms and requiring that firms maintain high levels of high-quality capital reserves in their U.S. legal entities. Likely the most consequential of the statute’s provi- sions was that which authorized Regulation YY, a landmark regulation that transformed capital planning and risk man- agement processes among financial institutions in the United States. Along with implementing enhanced prudential stand- ards for the U.S. operations of large, complex financial insti- tutions, Regulation YY altered the corporate structure of for- eign banking organizations (“FBOs”) by requiring large foreign banking institutions to establish a new legal entity, called an intermediate holding company (“IHC”). Put simply, IHCs were created to reorganize and capture, in one umbrella legal entity, all non-branch U.S. operations of FBOs. Further, to ensure robust, localized oversight of U.S. operations, each IHC is required to establish their own board of directors and risk committee, separate and apart from the board and com- mittees of the broader organization. IHCs are also required to comply with both the capital and leverage ratio requirements applied to similarly large domestic financial institutions, and the programmatic requirements associated with firms of that size (resolution planning, CCAR, CLAR).

There is another regulation, though, that when coupled with the far-reaching implications of Regulation YY has dis- parately impacted foreign banking organizations. That regu- lation is Regulation W, a longstanding regulation that limits the amount of intracompany transactions banking organiza- tions can engage in. Following the enactment of Dodd-Frank, Regulation W was amended in several ways which limited spe- cifically the types of transactions that FBOs often engage in with their affiliates to manage their liquidity risk and to ab- sorb liquidity shocks. The post-crisis changes made to Regula- tion W have already begun to be rolled back by U.S. regulators, however there has not yet been a detailed analysis of how spe- cifically the interaction between Regulation YY and Regulation W undermines global financial stability.

The specific aim of this Note is to evaluate whether Regu- lation YY and Regulation W have destabilized the global fi- nancial system. Institutions’ 2018 and 2019 CCAR results will be the lens through which the impact of the regulations is eval- uated. Specifically, we look at both institutions’ Tier 1 capital ratios and Tier 1 leverage ratios to assess how specifically the IHCs have positioned their liquid capital and adjusted their business model in response to Regulation YY reorganization. Ultimately, we conclude that the interaction between Regula- tion YY and the revised Regulation W has dramatically frag- mented the global flow of capital among FBOs. Regulation YY’s IHC reorganization mandate largely cabins foreign banks’ ability to absorb liquidity shocks through their organi- zations—a result that may pose a serious threat to global fi- nancial stability. That is, the fundamental disruption of insti- tutions’ ability to funnel liquidity to their network of legal entities around the world raises a significant concern regard- ing their resiliency during periods of stress, particularly for those systemically important firms who experienced pervasive liquidity issues in the most recent crisis.