UPDATE 3-Fed's Tarullo proposes raising foreign banks' costs

Wed Nov 28, 2012 7:53pm EST

* Tarullo gives three-pronged approach to stem risks

* Foreign banks would establish holding companies

* Align capital, liquidity standards with U.S. banks

By Jonathan Spicer and Douwe Miedema

NEW HAVEN, Conn./WASHINGTON, Nov 28 (Reuters) - A top Federal Reserve official launched a plan to subject foreign banks to the same tough oversight rules as their U.S. rivals, a policy shift that could make it less attractive for banks to do business in America.

Fed Governor Daniel Tarullo outlined a three-pronged approach that would force the largest U.S. divisions of foreign banks to establish holding companies over all subsidiaries. Under this proposal, the Fed would stop relying on foreign oversight of banks.

The proposal, which the Federal Reserve Board is now refining, would require foreign banks' U.S. holding companies to comply with the same capital rules that apply to U.S. banks, and it would make liquidity standards "broadly consistent" with domestic rules, he said.

Tarullo, who plays a leading role on regulatory issues at the U.S. central bank, characterized his plan as "a middle course" for foreign banks doing big business in the United States. He said he aimed to make it "minimally disruptive."

But foreign banks were not happy with the proposal.

"We're disappointed that Governor Tarullo's speech appears to signify a departure from the Federal Reserve Board's long-standing case-by-case approach when dealing with foreign banking organizations," Sally Miller, head of the Institute of International Bankers, said in a statement.

Tarullo's landmark proposal suggests that, four years after the worst of the financial crisis, regulators remain wary of the risks posed by big banks that do business globally, and are prepared to tighten the rules as a precaution.

"By imposing a more standardized regulatory structure on the U.S. operations of foreign banks, we can ensure that enhanced prudential standards are applied consistently across foreign banks," Tarullo told a Yale School of Management forum.

Details of the new rules are now under discussion at the Fed, Tarullo said, adding he expects the Fed's board to issue a more detailed notice of proposed rulemaking in coming weeks.

Earlier this month, the Fed said it would delay the so-called Basel III capital standards beyond a Jan. 1, 2013, deadline. That caused ripples globally, prompting some to worry that banks' intensive lobbying efforts succeeded in watering down and delaying post-crisis reforms.

PROBLEMS FOR EUROPEAN BANKS?

In late 2008 - in response to the financial crisis that began in the United States but spread globally - the Fed extended hundreds of billions of dollars in emergency loans to support the U.S. units of European banks.

Tarullo's proposal could crimp international funding schemes at European banks such as Barclays Plc and Deutsche Bank, and compel them to beef up capital in the United States, accountants said.

"The foreign banks are going to have to relook at the cost of doing business in the U.S. versus the benefits," said Dan Ryan, chairman of the financial services regulatory practice at accountancy firm PricewaterhouseCoopers.

"It will force a new look into the profitabilty of the U.S. operations and how much capital they need," he said.

The proposed rules could amplify criticism that regulators globally are not cooperating to set universal standards, complicating funding-market rules at a time that the world economy is still struggling to recover from recession.

The additional capital and liquidity buffers "may incrementally increase cost and reduce flexibility of internationally active banks that manage their capital and liquidity on a centralized basis," Tarullo acknowledged.

"However, managing liquidity and capital on a local basis can have benefits not just for financial stability generally, but also for firms themselves," he said.

Banks have relied increasingly on shorter-term funding and riskier trading over the last decade, Tarullo added, arguing that U.S. regulators cannot be "completely reassured" by the capital levels of foreign banks.

Tarullo surprised Wall Street last month by suggesting that Congress should cap the size of banks based on their share of U.S. gross domestic product.

Charles Horn, a partner in law firm Morrison & Foerster, said the financial industry had been expecting the Fed to put out tougher rules for foreign banks.

"We all knew that the Fed and the other regulators were going to turn up the regulatory heat on the U.S. operations of large foreign banks," he said.

But U.S. banks, which already face stricter capital and other requirements, would welcome the Fed's decision to toughen the rules for foreign banks, he said.