One often hears complaints that the emphasis on financial stability will result in the balkanization of international banking. I would note first that it is not at all clear that developments since the crisis have on net balkanized banking.
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Second, I wonder how these critics can think that the pre-crisis situation of supposedly consolidated oversight and substantial bank flexibility was a desirable one. At least some of the flexibility enjoyed by banks in shifting capital and liquidity around the globe was deployed in pursuit of unsustainable activity that eventually ran badly aground.

There are many models of regulatory coordination, but I shall focus on only two: the British and the American. As is well known, the United Kingdom has reformed financial sector regulation and supervision by setting up a Financial Policy Committee (FPC), located in the Bank of England; the major reforms in the United States were introduced through the Dodd-Frank Act, which set up a coordinating committee among the major regulators, the Financial Stability Oversight Council (FSOC).

In discussing these two approaches, I draw on a recent speech by the person best able to speak about the two systems from close-up, Don Kohn. Kohn sets out the following requirements for successful macroprudential supervision: to be able to identify risks to financial stability, to be willing and able to act on these risks in a timely fashion, to be able to interact productively with the microprudential and monetary policy authorities, and to weigh the costs and benefits of proposed actions appropriately. Kohn's cautiously stated bottom line is that the FPC is well structured to meet these requirements, and that the FSOC is not. In particular, the FPC has the legal power to impose policy changes on regulators, and the FSOC does not, for it is mostly a coordinating body.

After reviewing the structure of the FSOC, Kohn presents a series of suggestions to strengthen its powers and its independence. The first is that every regulatory institution represented in the FSOC should have the goal of financial stability added to its mandate. His final suggestion is, "Give the more independent FSOC tools it can use more expeditiously to address systemic risks." He does not go so far as to suggest the FSOC be empowered to instruct regulators to implement measures somehow decided upon by the FSOC, but he does want to extend its ability to make recommendations on a regular basis, perhaps on an expedited "comply-or-explain" basis.

Another reform that will take time to complete is the establishment of a global framework for resolving large, systemically important banks...  As many of you know, in the United States, the Federal Deposit Insurance Corporation is developing a preferred approach to resolution for such rare cases: the single-point-of-entry (SPOE) approach. This approach may be gaining some traction internationally. In my view, SPOE can be a classic "simplifier," making theoretically possible something that seemed impossibly complex.

Under the SPOE approach, the home country resolution authority for a failing banking firm would effect a creditor-funded parent company recapitalization of the failed firm. To do so, the resolution authority would first use available parent company assets to recapitalize the firm's critical operating subsidiaries, and then would convert liabilities of the parent company into equity of a surviving entity. This approach would have the effect of concentrating the firm-wide losses on the parent company's private sector equity holders and creditors. The SPOE approach places a high priority on what your own President Weidmann recently described as "the principle of liability," meaning that those who benefit should also bear the costs.

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I will briefly discuss the Fed's proposal for oversight of foreign banks operating in the United States, which carries out a mandate from the Congress under the Dodd-Frank Wall Street Reform and Consumer Protection Act.2 Our proposal represents a targeted set of adjustments aimed at reducing the risks posed by the U.S. operations of large foreign banks to U.S. financial stability that were revealed during, and in the aftermath of, the recent financial crisis. The proposal is not intended to create a disadvantage for foreign banks in the U.S. market. Rather, the proposal is part of a larger set of regulatory reforms that substantially raises standards for all banking organizations operating in the United States and aims to achieve the goals we share with Germany: vigorous and fair competition and a stable financial system. Indeed, in some sense it follows the lead of the European Union and its member states in ensuring that all large subsidiaries of globally active banks meet Basel capital rules. We believe that our foreign bank proposal, which would increase the strength and resiliency of the U.S. operations of these firms, would meaningfully reduce the likelihood of disruptive ring-fencing at the moment of crisis that could undermine an SPOE resolution of a large foreign bank. We are fully committed to the international efforts to address cross-border resolution issues and to maintaining strong cooperation between home and host supervisors during normal and crisis periods.

This profile of foreign bank operations in the United States changed in the run-up to the financial crisis. Reliance on less stable, short-term wholesale funding increased significantly. Many foreign banks shifted from the "lending branch" model to a "funding branch" model, in which U.S. branches of foreign banks were borrowing large amounts of U.S. dollars to upstream to their parents. These "funding branches" went from holding 40 percent of foreign bank branch assets in the mid-1990s to holding 75 percent of foreign bank branch assets by 2009. Foreign banks as a group moved from a position of receiving funding from their parents on a net basis in 1999 to providing significant funding to non-U.S. affiliates by the mid-2000s--more than $700 billion on a net basis by 2008.

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Finally, we should note that one of the fundamental elements of the current approach--our ability, as host supervisors, to rely on the foreign bank to act as a source of strength to its U.S. operations--has come into question in the wake of the crisis. The likelihood that some home-country governments of significant international firms will backstop their banks' foreign operations in a crisis appears to have diminished. It also appears that constraints have been placed on the ability of the home offices of some large international banks to provide support to their foreign operations. The motivations behind these actions are not hard to understand and appreciate, but they do affect the supervisory terrain for host countries such as the United States.

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At the same time, in modifying our regulatory regime for foreign banking organizations, we must remain mindful of the benefits that foreign banks can bring to our economy and of the important policies of national treatment and comparable competitive opportunity. Thus, we should chart a middle course, not moving to a fully territorial model of foreign bank regulation, but instead making targeted adjustments to address the risks I have identified. In basic terms, three such adjustments are desirable.

First, a more uniform structure should be required for the largest U.S. operations of foreign banks--specifically, that these firms establish a top-tier U.S. intermediate holding company (IHC) over all U.S. bank and nonbank subsidiaries. An IHC would make application of enhanced prudential supervision more consistent across foreign banks and reduce the ability of foreign banks to avoid U.S. consolidated-capital regulations. Because U.S. branches and agencies are part of the foreign parent bank, they would not be included in the IHC. However, they would be subject to the activity restrictions applicable to branches and agencies today as well as to certain additional measures discussed below.

Second, the same capital rules applicable to U.S. BHCs should also apply to U.S. IHCs...

Third, there should be liquidity standards for large U.S. operations of foreign banks... 

In prepared remarks, Evans said the financial crisis revealed weaknesses "in our increasingly interconnected, global financial system."

I would suggest that the financial stability issues raised in 2008, and which have become increasingly prevalent of late, require a reexamination of issues that influence the stability of short-term credit markets.

[T]he current international monetary system is a mixture of economies, some with open capital accounts and flexible exchange rates, and others with managed exchange rates, more-restricted capital mobility, and more-limited monetary policy independence. Many of these latter economies also have current account surpluses, in part because authorities have been able to resist currency appreciation, and thus inhibit external adjustment, for prolonged periods. This feature of the international system inhibits the process of global rebalancing and could restrain the current recovery.

Too often the questions asked are: What is most beneficial to the banks of my particular country? Do the regulations bolster or harm my "national champion"? The focus shifts away from the goal of bolstering global financial stability to finding ways of tilting or adjusting the new standards to achieve a national competitive advantage.

This is in not in anyone's interest. As discussed earlier, every nation has an interest in promoting financial stability globally, since the effects of systemic financial stress in one place can swiftly spread throughout the global economy. Moreover, although a relatively loose regulatory regime may attract business from other financial centers, there is no free lunch here. A more lax regulatory regime is likely to expose that country’s taxpayers to huge tail risks.

[W]e currently operate with a financial system that is largely regulated on a country-by-country basis.

This is not tenable. What’s required is not some global authority dictating what national authorities can do but instead greater cooperation and trust in exchanging information and agreement on harmonized standards such as those laid out in the Basel III capital requirements and the CPSS-IOSCO Principles for Financial Market Infrastructures. There needs to be a good faith commitment to try to achieve a level playing field. The regulations and supervisory practices that are put in place should be determined by what is good for the public good writ large, rather than what benefits some narrow set of private financial institutions or markets.

We need a system characterized by more open capital accounts, flexible exchange rates, and independent monetary policies. Open capital accounts, supported by appropriate financial supervision and regulation, channel savings to their most productive uses, thereby enhancing welfare. Exchange rate flexibility improves domestic macroeconomic management, allowing countries to pursue independent monetary policies tailored to their individual needs, and limits unwelcome spillovers to other economies. Such a system can also flexibly adapt to changing economic and financial realities as countries develop, technology progresses, and shocks buffet the global economy.

Our current international monetary system does not yet fulfill these objectives.

The preferences of foreign investors for highly rated U.S. assets, together with similar preferences by many domestic investors, had a number of implications, including for the relative yields on such assets. Importantly, though, the preference by so many investors for perceived safety created strong incentives for U.S. financial engineers to develop investment products that "transformed" risky loans into highly rated securities...

To be clear, these findings are not to be read as assigning responsibility for the breakdown in U.S. financial intermediation to factors outside the United States. Instead, in analogy to the Asian crisis, the primary cause of the breakdown was the poor performance of the financial system and financial regulation in the country receiving the capital inflows, not the inflows themselves. In the case of the United States, sources of poor performance included misaligned incentives in mortgage origination, underwriting, and securitization; risk-management deficiencies among financial institutions; conflicts of interest at credit rating agencies; weaknesses in the capitalization and incentive structures of the government-sponsored enterprises; gaps and weaknesses in the financial regulatory structure; and supervisory failures. In reflecting on this experience, I have gained increased appreciation for the challenges faced by policymakers in emerging market economies who have had to manage large and sometimes volatile capital inflows for the past several decades.

Basel III is not a perfect agreement, of course. There are things we would have done differently if we were writing a capital regulation on our own... But it is a major step forward for capital regulation. It will raise minimum requirements substantially, ensure that regulatory capital is truly loss absorbing, and discourage some of the risky activities for which the pre-crisis regime required far too little capital.

If such organizational complexity [of large financial institutions] imposes a high social cost by impeding recovery plans and resolution, providing incentives to reduce complexity may be warranted. For example, collateralization or capital requirements on intragroup exposures or parent guarantees could internalize for the firm some of those social costs. Alternatively, more direct supervisory requirements may be necessary for addressing the improvement of information systems or the separability and preservation of critical payment systems.

As we have seen during the recent global crisis, the interconnectedness of financial markets goes beyond our domestic borders. It is obvious that we need to do a better job of identifying cross-border linkages and their associated risks. Greater coordination across regulatory frameworks could be tremendously helpful in this effort.

[T]here are aspects of the Dodd-Frank Act that are unlikely to become part of the international financial regulatory framework. For example, the act generally prohibits U.S. banking firms (and the U.S. operations of foreign banking firms) from engaging in proprietary trading and from investing in or sponsoring private investment funds. The act also prohibits U.S. depository institutions from entering into certain types of derivatives transactions. In the United States, activity restrictions have long been a part of the bank regulatory regime, serving to constrain risk-taking by banking firms, prevent the spread of the market distortions caused by the federal bank safety net to other parts of the economy, and mitigate potential conflicts of interest generated by the combination of banking and certain other businesses within a single firm. Many other countries follow a universal banking model and are unlikely to adopt the sorts of activity restrictions contained in the act.