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Fed ends foreign banks' game of musical chairs

February 24, 2014: 9:47 AM ET

The supervisors at the Fed are right to set some boundaries to protect both America and foreign countries from financial risk-takers.

By Sheila Bair

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FORTUNE -- It never ceases to amaze me how sound bites can drive the debate over financial reform. Take reaction to the Federal Reserve Bank's decision last week to impose on the U.S. operations of foreign banks roughly the same capital and liquidity requirements applicable to our domestic banks. Capital and liquidity rules are important as they help ensure that foreign banks serving U.S. customers remain solvent and have enough cash to meet their obligations, even in times of economic stress. And why shouldn't these foreign banks have to adhere to the same rules as American institutions, particularly when many of them had to borrow heavily from the Fed during the financial crisis to stay afloat?

But to hear the amnesiac-laden chatter of impacted banks and their apologists (as well as certain members of the press who should know better), the Fed has smeared apple pie into the face of all-American capitalism. They accuse the Fed of "fragmenting global finance" and "impeding the international flow of capital." Well, compared to the system we had, what's wrong with that? Prior to the crisis, foreign banks were free to move their capital and liquidity around pretty much wherever they wanted. Playing a dangerous game of musical chairs, they just kept circulating it around the globe, mostly taking money out of the U.S. and sending it elsewhere. This model, of course, worked fine until the financial crisis yanked the plug from the CD player, and they needed that money everywhere at once. Many would have fallen on their bums if the Fed had not quickly provided some extra chairs.

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It is, of course, much cheaper for globally active banks to escape capital and liquidity rules in foreign jurisdictions, particularly when their home country regulators' rules are weak. But eating into banks' profit margins should not dissuade regulators when financial stability is at stake. In fact, many foreign banks have, for decades, willingly subjected themselves to the prudential rules of each country where they do business, and have still made healthy profits. London's HSBC (HSBC), Spain's BBVA (BFR), and Grupo Santander (SAN) are three banking organizations that have long followed this model. (Disclosure, I recently joined the Santander board.)

Moreover, the only capital that is "impeded" is the minimum amount necessary to meet U.S. regulatory and stress tests requirements. If a U.S. subsidiary meets those requirements, it will be free to send excess profits to its foreign parent. U.S. banking organizations must abide by much the same limitations. They are precluded from making capital distributions unless regulators are satisfied that they will still have enough on hand to remain solvent, even in a severe downturn.

Critics have also argued that the Fed's new rules will make it more difficult to handle the failure of a large internationally active bank by segregating its U.S. operations into a separately capitalized subsidiary. On the contrary, the Fed's rules will provide regulators with more flexibility to respond to such failures. If the foreign parent becomes troubled, it will be much easier to sever the American subsidiary from the ailing parent. Conversely, if the U.S. operations become troubled, containing them in a separate subsidiary will help prevent those troubles from spreading beyond our shores. Most importantly, by requiring larger capital and liquidity buffers, the Fed's rules will reduce the risk that a foreign bank's American operations will run into trouble in the first place.

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Going on six years since the financial crisis, U.S. financial regulators still struggle to complete necessary reforms in the face of fierce opposition from much of the financial services industry. Supporters of tougher regulations are met with loud demands for reams of documentation and cost-benefit analysis to justify them. Yet, critics too often get by with overused sound bites about "contracting credit" or "impeding capital flows."

While financial globalization has had its benefits, it has also raised the risk of losses from financial excess in one country spreading rapidly to others. The supervisors at the Fed are right to set some boundaries to protect both America and foreign countries from financial risk-takers who just don't know when to leave the dance. We should all, including the media, stand up and applaud its actions. Hopefully, the next time the music stops in the financial cycle, both foreign and U.S. banks will be supplying their own chairs.

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About This Author
Sheila Bair
Sheila Bair
Contributor, Fortune

Sheila Bair is a Fortune contributor, and a former chair of the FDIC, and former member of the Basel Committee. She is also the author of the New York Times bestseller Bull by the Horns, Fighting to Save Main Street from Wall Street and Wall Street from Itself.

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