A couple of years ago, I sat on a closed-door “summit” of industry analysts convened by a global agency to assess whether subsidiarization – i.e., ring-fencing host-country banking operations – makes policy sense. You didn’t see our report? That’s because we were deadlocked. Sometimes, subsidiarization makes the parent stronger; sometimes, it suits the sub. Always, it suits the regulator because it knows where the pieces for which it is responsible lie. But, almost never is subsidiarization good for financial-system stability – under stress, capital and liquidity are trapped to the good of the sub at grave harm to the parent’s survival or that of another sub posing systemic risk in a third jurisdiction.
Press coverage of the European Commission subsidiarization demand generally attributes it to a desire for vengeance against the FRB’s rule requiring large foreign banks to consolidate much of their operations here into intermediate holding companies (IHCs). Vengeance perhaps, but surprisingly late given that these rules were finalized in February of 2014 and IHCs had to be in place this summer. The underlying rationale for the EC’s proposal is far more likely to be a combination of Brexit retribution combined with a hail-Mary pass aimed at cushioning weak Eurozone banks from the competitive drubbing they’ve been getting from U.S. banks.
However, mauling the U.S. and Britain for being mean to Europe or cushioning weak banks ignores the far more lasting question of what happens when a large cross-border bank falters or, worse, fails. The U.S. IHC construct is intended as a way to ensure that U.S. operations are not suddenly endangered by a large foreign bank’s home-country problems or – an even greater challenge from the FRB’s perspective – home-country government’s demands that capital or liquidity be repatriated in a manner that could jeopardize the foreign bank’s outstanding exposures to the U.S. central bank.
The U.S. is also busy ring-fencing its own GSIBs out of fears of host-country government action under stress. As we noted in our analysis of the latest round of FRB/FDIC living-will judgments, much of the censure of these plans was due not to bank complexity or confusion, but rather to uncertainty about what a host-country government would do to branch operations or other balances domiciled outside the U.S.
Thinking only about itself, the U.S. is right just as the European Commission is with regard to the still more daunting complexities of European resolutions in the absence of anything close to a harmonious resolution scheme or a deposit-insurance system among the 27 nations left in the EU after Britain goes its own way. Ring-fencing puts all the pieces of a bank in their geographic place, creating clear piles of assets and liabilities for each resolution authority to clean up as it chooses. So, on a host-country resolvability criterion, subsidiarization makes sense.
Where’s the harm? Banks may be easier to resolve in a crisis following ring-fencing, but crises are also made a lot more likely. Integrated cross-border bank-branch operations have efficiencies that make them the go-to strategy – the parent can quickly mobilize capital, liquidity, and governance resources to the spot at which they are most needed. This is of course good for profitability, as one gets a lot of double leverage across the holding-company system as a result of all of these shared resources.
But efficiencies also enhance resolvability because they enhance consolidated capital adequacy, including by way of retained earnings. They thus permit the strong to protect the weak across a holding-company structure, allowing the parent to rob Peter to pay Paul to make the family as a whole richer in the long run. Under acute stress, the parent can also rob both Peter and Paul to save itself, the scenario host countries fear but one on which global financial stability nonetheless depends.
Fans of the leverage requirement love its simplicity, disregarding the downside risks resulting from the complexity of modern finance. Subsidiarization fans are similarly simple-minded – not stupid, mind you, but determined nonetheless to make easy what’s actually really hard. This financial-policy strategy is directly analogous to the complaints about cross-border trade that created Brexit and empowered Donald Trump. Each nation saves itself – or so it thinks – but the whole of global finance suffers, and badly.