An Open Letter to Congressman Patrick McHenry

“Despite the clear message delivered by President Donald Trump in prioritizing America’s interest in international negotiations, it appears that the Federal Reserve continues negotiating international regulatory standards for financial institutions among global bureaucrats in foreign lands without transparency, accountability, or the authority to do so. This is unacceptable.”
Letter from Representative Patrick McHenry, Vice Chairman, House Financial Services Committee, to Federal Reserve Chair Janet Yellen, January 31, 2017

Dear Vice Chair McHenry,

We find your January 31 letter to Federal Reserve Board Chair Janet Yellen both misleading and misguided.

It is in the best interest of U.S. citizens and our financial system that the Federal Reserve (and all the other U.S. regulators) continue to participate actively in international financial-standard-setting bodies. The Congress has many opportunities to hold the Fed accountable for its regulatory actions, which are very transparent. We hope that the new U.S. Administration will support the Fed’s efforts to promote a safe and efficient global financial system.

Your letter is filled with false assumptions and assertions. We will focus on three: (1) that the Federal Reserve is negotiating “binding” standards that are not subject to domestic review and do not “prioritize America’s best interests;” (2) that past agreements "unfairly penalized the U.S. financial system;" and (3) that higher capital requirements (arising from the application of mutually agreed international standards) are “leading to slower economic growth here in America.”

First, international forums such as the Financial Stability Board (FSB) and the Basel Committee on Banking and Supervision (BCBS) do not establish “binding” standards. Each country (and each regulator within that country) is free to choose whether to implement the minimum standards for internationally active financial institutions agreed by the 27 jurisdictions involved in the BCBS and FSB. This means first and foremost that no U.S. regulator, including the Fed, is obligated to put these standards into effect. It also means that, even if they choose to adopt domestic rules that meet the global minimum, as U.S. officials generally have in the past, the resulting regulations need only apply to the very small number of large globally active intermediaries. Furthermore, the fact that these are minimum standards means that a jurisdiction can put in place tougher regulations than those agreed at the BCBS or FSB; something U.S. officials frequently do. There is no sense in which international agreements require actions that “unfairly penalize the American financial system.” Instead, U.S. regulators are deciding to implement global rules voluntarily because they find them useful.

Second, the United States typically chooses to enforce global standards precisely because they have been set in a way consistent with U.S. interests. For example, the first Basel agreement, reached in 1988 during the Reagan Administration, aimed to establish a level playing field for U.S. internationally active banks by promoting common capital standards. The alternative, many feared, was a global financial system dominated by the undercapitalized banks from countries that protected them with implicit or explicit national guarantees—a system where U.S. banks, with less extensive government backing, would be at a disadvantage.

More recently, in the aftermath of the 2007-2009 financial crisis, the United States has promoted higher capital requirements internationally to make it safe for U.S. intermediaries to do business with banks elsewhere, and to limit the risks that increase the likelihood of another global crisis. Where there has been resistance to these U.S. efforts, it has often come from countries that provide guarantees to their financial firms. In the absence of FSB efforts, such as the standard for total loss-absorbing capital (TLAC), we expect that many of these countries would permit their banks to continue to operate with thin capital buffers that expose U.S. banks and firms to risks of another global crisis.

To put it bluntly, without internationally agreed capital standards, we are sure that the banks of some of the largest European countries would be significantly less safe than they are today. It is in the Basel-based committees that the United States encourages others to adopt practices aimed at making the global financial system safe.

Third, contrary to your assertion, by making our financial system safer, higher capital requirements lead to faster and healthier, not to slower, economic growth. The equity capital of intermediaries is not an idle, wasted resource. Like deposits, bonds and other forms of debt, it is a source of funding for the assets on the balance sheet. Plentiful capital means that the risks banks and others take will be borne principally by their shareholders, as should be the case in a market-based, free-enterprise system.

A range of research supports the conclusion that well-capitalized banks are inclined to lend more and to make higher-quality loans than other banks. International evidence is compelling: better-capitalized banks experience lower funding costs, higher growth of debt funding, and higher growth of lending volumes. In other words, countries with better-capitalized systems can grow faster. In contrast, regulatory forbearance in Japan in the 1990s and in the euro area more recently resulted in the evergreening of poor loans to zombie firms, dragging growth down. This is all consistent with the U.S. experience, where increases in the level of equity capital in the commercial banking system are positively associated with the level of credit as a share of GDP.

We are sure you would agree that everyone has an interest in a safe, efficient global financial system. The free flow of capital across borders facilitates trade in goods and services, boosting economic efficiency. The ability of U.S. and foreign citizens to buy and sell foreign assets is good for both the buyers and the sellers. Today, U.S. residents own nearly $25 trillion of assets abroad, while foreigners own more than $32 trillion of U.S. assets. These holdings, which sum to about three times U.S. annual income, are a sign of the enormous confidence investors have in the global financial apparatus.

Indeed, the United States, which did more than any other country to foster free capital flows, is a leading beneficiary of today’s globally integrated financial system. The biggest U.S. banks operate in as many as 140 countries, while hundreds of foreign banks and intermediaries from scores of countries have enormous stakes in the United States. Together, this sustains the Global Dollar System, in which our currency accounts for 88% of the $5 trillion traded daily in foreign exchange markets and for more than half of world trade finance, even though the U.S. economy produces only about one-fourth of world GDP. Confidence in this system is so great that U.S.-dollar-denominated liabilities outside the United States exceed the total liabilities of the commercial banking system inside the United States. This system raises the standard of living of every American. Eroding the confidence that supports it would pose a serious threat not only to global finance, but to the value of the dollar, to the value of assets in the United States, and to the American economy.

Sustaining a strong global financial system requires cooperation and coordination in regulation. In a world of open capital flows, disturbances that start in one part of the system can be rapidly transmitted elsewhere. A country must be confident that the counterparties of its banks are solid: it cannot be left bailing out its banks because of the failure of foreign borrowers. As President Reagan emphasized in the context of arms control agreements, such confidence requires more than mere trust; it requires verification. Global financial standard-setting, where members of the BCBS and the FSB first negotiate mutually beneficial agreements and then monitor each other’s implementation, is the verification mechanism for the global financial system.

We find it impossible to believe that the United States, which has led international coordination efforts since the end of World War II, would choose not to meet global standards. Were it to do so, foreign countries would hesitate to allow their intermediaries to do business with those in the United States, let alone allow our banks to operate inside their borders. The resulting isolation of American banks would diminish foreign investment in the United States and have severe implications for the use of the dollar. Were it to undermine the dollar’s role as the world’s leading reserve currency, the result could be catastrophic, leading foreign investors to shun U.S. assets. That really would be a job killer.

What this means is that it is in everyone’s interest for our leading international banks to meet global standards. They will have no choice. In light of this fact, shouldn't we encourage our officials to continue their active participation in the formulation and refinement of those standards? Shouldn’t we seek to counter weaknesses in financial systems abroad that could harm the U.S. economy? Given the past success of the Federal Reserve and other U.S. regulators who have been negotiating international agreements on our behalf, we see no reason to stop.

Despite its size, the U.S. financial system and the economy cannot prosper in isolation. An interdependent and interconnected global financial system poses both opportunities and risks that need to be managed. We expect that the new Administration, like those since President Truman over the past seven decades, will recognize these fundamental truths and continue to pursue cooperation and coordination that benefits us all. We hope that you will, too. 


Stephen G. Cecchetti and Kermit L. Schoenholtz