NEW YORK - Federal Reserve Governor Daniel Tarullo will raise a number of concerns about the Dodd-Frank banking law before Congress Thursday, including foreign central bank complaints that one provision could "interfere" with how they conduct their monetary policies.
Testimony prepared for the Senate Banking Committee released Wednesday evening shows Tarullo also raising concerns about the cross-border implications of how Dodd-Frank would affect so-called "systemically important financial institutions" (SIFIs) should the be put in receivership by U.S. regulators.
Even domestically, he said SIFIs -- better known as "too big to fail" banks -- would have to hold very large amounts of unsecured debt under a proposal by the Federal Deposit Insurance Corporation, which would be principally in charge of "resolving" any SIFI that became insolvent.
Tarullo acknowledged ongoing disagreements about the so-called "Volcker Rule," which restricts banks' ability to trade with their own money.
Throughout his testimony before the Senate committee Tarullo stressed the need for international cooperation and global "convergence" on capital and liquidity standards, bank trading restrictions, SIFI resolution policies and derivatives regulation.
Regarding the latter, he said there are "key areas of OTC derivatives reform" that present "international challenges" and "will demand similar levels of international collaboration."
"These areas include the creation and regulation of central counterparties, swap execution facilities, and swap data repositories, including mutual recognition by U.S. and foreign regulators where appropriate," he said.
"Issues also arise around the treatment of governmental entities in derivatives reforms in the United States and abroad," Tarullo continued. "For example, Title VII of the Dodd-Frank Act generally exempts from swaps regulation any transaction to which the Federal Reserve is a party, but does not contain a similar exemption for transactions to which a foreign central bank is party."
Tarullo said "foreign central banks have expressed concerns that the application of certain parts of title VII may interfere with the manner in which they conduct their national monetary policies."
He did not elaborate.
But the European Central Bank made plain its concerns about how Dodd-Frank would affect such things as currency swaps when its General Counsel Antonio Sainz De Vicuna wrote last October to the Commodity Futures Trading Commission's director of international affairs Jacqueline Mesa.
Noting that the ECB enters into a variety of operations in currency, precious metals and securities markets and that it uses "over-the-counter derivatives" involving its foreign reserve assets, the ECB lawyer wrote that "swaps activity of the ECB should be exempt from regulation under the Dodd-Frank Act."
Title VII of Dodd-Frank establishes a new regulatory frramework for swaps with the stated aim of reducing risk, increasing transparency and promoting market integrity. But De Vicuna wrote that "these objectives are not achieved by applying the requirements of Title VII to the ECB or transactions with its counterparties."
"The ECB's primary objective is to maintain price stability, and the ECB also contributes to the stability of the overall financial system," De Vicuna wrote. "Any regulations that constrain the ECB's activities in the U.S. or with U.S. parties will have the perverse consequence of making it more difficult for the ECB to reduce risk and maintain the integrity of the financial system."
"In addition, imposing transparency requirements on the ECB will not achieve greater transparency for the swap market," he said, because "the ECB's trades are not ordinary commercial trades that are comparable with other transactions."
Noting that the ECB has been granted immunity by other U.S. legislation, De Vicuna said "the purpose of this immunity will be defeated if the activities themselves are subject to extensive regulation."
"Moreover, imposing regulatory requirements on the ECB's swap activities will result in unequal treatment between the ECB and the Federal Reserve, which is exempted from swap regulations under the Dodd-Frank Act," De Vicuna went on, adding that this would violate another provision of Dodd-Frank requiring that U.S. regulators coordinate with foreign regulators to achieve "consistent international standards."
De Vicuna also expressed concern that Title VII, unless amended, would set a bad precedent. "If the U.S. gives preferential treatment to the Federal Reserve for purposes of swap regulation, then other jurisdictions are likely to exempt their home country central banks but not foreign central banks."
"Such unequal treatment would significantly hamper international cooperation and restrict the ability of central banks to manage global markets," he warned.
"Further, if regulatory requirements are imposed on foreign central banks, the ECB and other foreign central banks may shift swaps activity away from the U.S. market or U.S. counterparties," De Vicuna warned. "This would reduce the liquidity of U.S. markets, constrain the competitiveness of U.S. parties, and reduce the effectiveness of central bank actions."
Dodd-Frank provides for the FDIC to spearhead the "orderly resolution" of SIFIs if and when they get into trouble. But Tarullo suggested that the way in which different countries handle bankruptcies of large internationally active bank holding companies also presents potentially thorny, internationally disputatious issues.
"In developing the orderly liquidation authority established by Title II of the Dodd-Frank Act, the FDIC has recently expressed a preference for resolving a failed SIFI under a single receivership and internal recapitalization model," he noted.
Under the FDIC proposal, he explained "the parent company of the failed SIFI is placed into receivership; all, or substantially all, of the assets of the parent company are transferred to a bridge entity; the parent company and its residual assets are liquidated; and the bridge entity is capitalized, in part, by converting the holders of long-term unsecured debt of the parent company into equity holders in the bridge. Under the single receivership model, the major subsidiaries of the SIFI continue to operate as going concerns."
Tarullo said the FDIC approach "holds great promise," but added that "ensuring its viability as a resolution option requires, among other things, that each SIFI maintain an amount of long-term unsecured debt that is sufficient to absorb very significant losses at the firm."
What's more, there could be conflicts with other countries, he suggested.
"Some other jurisdictions have, or are planning to, put in place special resolution mechanisms that conform to the emerging international standards," he said. "But even continued progress along this path may not solve all the possible problems associated with failure of a SIFI."
"The coexistence of internationally active firms with nationally based insolvency regimes means that there could be important cross-border legal complications when a home jurisdiction places into receivership a firm with significant assets, subsidiaries, and contractual arrangements in other countries," he said.
And Tarullo said "a comprehensive, treaty-like instrument for a global bank resolution regime to address these issues is surely an unrealistic prospect for the foreseeable future."
He said the Fed and the FDIC are "working together with counterparts from other countries to identify opportunities for more limited cooperation agreements, coordinated supervisory work on resolution plans, and other devices to make the orderly resolution of a large, internationally active firm more feasible."
Regarding the Volcker Rule, which has been stirring controversy and confusion among banks here and abroad for months, Tarullo acknowledged that "concerns have been expressed about the Volcker Rule's potential international implications in three principal areas:
--"First, because the Volcker Rule applies to the worldwide operations of U.S. banking entities, but only to the U.S.-connected operations of foreign banks, concerns have been raised regarding the relative competitiveness of U.S. firms that have significant operations in overseas markets.
--"Second, and conversely, because the Volcker Rule also applies to the activities of foreign banks unless such activities are 'solely outside the United States,' several foreign banks and their supervisors have expressed concern regarding the potential extraterritorial impact that those restrictions may have on trading or fund activity of foreign banks that has both U.S. and non-U.S. characteristics.
--"Third, because the Volcker Rule includes a statutory exemption for proprietary trading in U.S. government debt securities, but not in foreign sovereign debt securities, several constituencies have raised concerns regarding this asymmetry."
Tarullo said that "in each of these areas, U.S. regulators will need to carefully consider the concerns that have been raised and the broader international implications of the Volcker Rule as we work to finalize our implementing rules.
Tarullo also foresaw problems with the so-called swaps "push-out" requirement in section 716 of the Dodd-Frank Act, under which U.S. insured depository institutions and U.S. branches and agencies of foreign banks will be required to "push out" certain types of derivatives dealing activities to affiliated entities.
He said that "appears unlikely to be pursued internationally."
"The global effects of the swaps push-out provision are multifaceted," he said. "On the one hand, the provision will require U.S. banking firms to restructure their global derivatives dealing activities in ways that will not be required of foreign banks abroad. At the same time, the provision may require U.S. branches and agencies of foreign banks to restructure their derivatives dealing activities in ways that will not be required of U.S. banks."
Title VII is not the only part of Dodd-Frank that has aroused foreign central banks' ire.
A letter from Bank of Canada Governor Mark Carney to Fed Chairman Ben Bernanke typifies the kinds of complaints that foreign central banks and other institutions have been making about Section 619 of Dodd-Frank -- the "Volcker Rule."
Carney, in a Feb. 13 letter to Bernanke and other top U.S. financial regulators, wrote that "the proposed rule appears to extend well beyond U.S.-insured depository institutions and imposes significant restrictions on Canadian banking entities by limiting their use of U.S.-based resources, personnel and market infrastructure and by preventing them from trading with U.S. counterparties."
"These restrictions may have important adverse consequences for Canada, limiting the liquidity of Canadian markets and hence the resilience of the Canadian financial system," Carney continued. "Indeed, the proposed rule may undermine, rather than support, progress toward creating a safer, more resilient and more efficient global financial system."
Carney warned that "market-making and risk-management activities by Canadian banks may be limited" because of the Volcker Rule.
The proposed rule provides exemptions for activity that is "solely outside of the United States" has well as for market-making and risk-management activities. But Carney said "as currently written, the exemptions are narrow and may prevent a great deal of trading activity that supports financial stability and efficiency in Canada...."
"Canadian banks may limit hedging, market-making and underwriting activities involving U.S.-based resources and U.S. counterparties to avoid potential non-compliance with the proposed rule," Carney went on. "The difficulty of distinguishing legitimate market-making activities from prohibited proprietary trading could reduce trading activity and could severely disrupt the liquidity and resilience of Canadian financial markets."
Carney also expressed fear that "trading in Canadian government bonds may be impaired, restricting competition and liquidity in these markets."
U.S. government securities are excluded from the Rule's restrictions on proprietary trading, but not foreign government securities. And Carney argued that "the same reasoning applies to government securities in other jurisdictions, and these securities should therefore be excluded from the proprietary trading restrictions of the proposed rule."
"Without this clear exemption, the proposed regulations could restrict Canadian banks' transactions in Canadian government securities involving U.S. infrastructure or counterparties," he warned. "Similarly, the restrictions on U.S. banks' participation in the market for Canadian government securities would restrict competition and liquidity in these markets and ultimately undermine the resilience of the Canadian financial system."
Finally, Carney charged that "the use of U.S.-based global market infrastructure may be curtailed, hindering progress in implementing global initiatives to promote financial stability."
"Based on the proposed language, it would appear that the 'solely outside of the United States' standard could prevent Canadian banks from engaging in some trading that incidentally uses financial infrastructure located in the United States," he wrote.
Tarullo appears with Treasury Under Secretary for International Affairs Lael Brainard and the acting heads of the FDIC and Office of Comptroller of the Currency.
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