The Federal Reserve moved Tuesday to correct one of the main causes of the 2008 financial crisis, ordering the nation’s largest domestic banks and foreign ones operating in the United States to hold more capital in case things go bad.
The long-anticipated rule covers banks both domestic and international with assets above $50 billion. It was required as part of the sweeping revamp of financial regulation back in 2010 that followed the most devastating financial crisis since the Great Depression. It aims to reduce system-wide risks.
Before the crisis, large interconnected financial institutions, many of them global in scale, were spottily supervised or had portions of their businesses supervised by multiple regulators. No one regulator was seeing the complete picture of the financial institution’s activities and risks.
“As the financial crisis demonstrated, the sudden failure or near failure of large financial institutions can have destabilizing effects on the financial system and harm the broader economy,” said Janet Yellen, the new Fed chairwoman. “And as the crisis also highlighted, the traditional framework for supervising and regulating major financial institutions and assessing risks contained material weaknesses.”
The rule, she said, would “help address these sources of vulnerability.”
Giant foreign banks operating in the United States would have to create U.S.-based intermediate holding companies that would be regulated by the Fed and would be subject to stricter capital requirements and enhanced risk-management efforts. They’d essentially be treated as if they were domestic banks.
In a nod to pressure from overseas, the Fed gave foreign banks an extra year to comply, said a senior Fed official, briefing the media under the condition of anonymity before the rule was made public.
The rule doesn’t specify an exact number for how much capital must be kept in reserve. Instead, each bank will develop a capital plan annually that must pass the Fed’s stress tests, which try to determine what would happen to assets in a galloping crisis like that of 2008. This testing will determine how much a bank must have on hand. Foreign banks also will have to pass an equivalent stress test in their home countries.
The rule “marks another important milestone” in correcting the defects in past financial regulation, Yellen said.
In 2008, when giant investment banks were toppling like dominoes, regulators were shocked to find that many were highly leveraged, meaning they’d invested far more than they had on hand. They were also highly dependent on short-term lending to stay afloat. When banks suddenly stopped lending to each other, it quickly became a game-over situation, and the U.S. taxpayer was forced to inject capital on the largest banks to ensure their solvency.
To address this, the new rule also requires more holdings that can be sold off quickly in a crisis, lowering the reliance on short-term dollar loans that amplified the crisis in 2008.
The Fed also adopted regulatory changes for publicly traded domestic banks and foreign banks with assets above $10 billion. They’ll be required to create special risk committees and be subjected to stress testing to determine how much capital they need to keep on hand to fend off emergencies and prevent the need for government bailouts like the controversial ones that marked the financial crisis.
Federal Reserve staffers expect that 24 large U.S. bank holding companies and 100 foreign banks will fall under the new rules. Of the 100 foreign banks, about 15 to 20 would be required to form a U.S. intermediate holding company if they wanted to continue operating in the U.S. marketplace. The rule would take effect on Jan. 1, 2015, for giant U.S. banks and by mid-2016 for large foreign banks.
The rule does not cover giant non-bank lenders such as insurance companies with investment operations, but the Fed said these non-bank lenders, sometimes called shadow banks, would be subjected to similar enhanced supervision by an individual rule or order.
That may be a weakness over time, warned Bert Ely, a banking industry expert who rose to acclaim during the savings and loan crisis of the 1970s and 1980s.
“What this may do over time . . . is spark growth in the shadow-banking system,” he said. “The more cost that gets laid on the highly regulated banks, the greater the incentive to create new types of mechanisms. I think people are kidding themselves if they think that this decreases systemic risk. It may increase it over time.”