The Fed is backing foreign banks into a corner by Cyrus Sanati @FortuneMagazine December 3, 2012, 5:08 PM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons FORTUNE — Big banks like Barclays and Deutsche Bank could soon find it a lot more expensive to do business on Wall Street. The Federal Reserve telegraphed to the markets late last week that foreign financial firms operating in the U.S. won’t get a pass on all the new regulatory red tape associated with the Dodd-Frank financial reform. While that may be the “fair” thing to do, it could make some international firms think twice about whether it’s worth doing business in the U.S. Wall Street is so international now that it has become increasingly difficult to tell which firms are foreign and which are domestic. One could probably spend a whole day walking around Deutsche Bank’s downtown New York offices and never even see a German. The same could be said for finding a Swiss national over at Credit Suisse. Meanwhile, if you go into the CEO’s office at Morgan Stanley you’ll hear an Australian, not an American, accent. Indeed, most of the big foreign firms that made their way into the U.S. market have done so by acquiring a U.S. investment firm with roots already established in the financial world. For example, Credit Suisse CS acquired DLJ and First Boston; UBS UBS acquired Warburg and Paine Webber; and Barclays BCS notoriously acquired Lehman Brothers at the height of the financial crisis. The Americans staffed at those firms mostly stayed on and their clients came with them. Foreign financial firms have been critical to the U.S. banking system for many years, making up half of the top 10 broker dealers operating in the U.S. Indeed there is evidence that a large portion of the money raised in the U.S. by European banks was recycled back into the U.S. market. Many have consolidated their broker dealer operations, not in their home country or in London, but on Wall Street. Indeed, the top-10 foreign banks rose from 13% of all foreign bank third-party assets in 1995 to 50% in 2011, according to the Federal Reserve. MORE: Morgan Stanley CEO: More bank deals on the way But one way you can tell a foreign firm from a domestic one is to look at how it’s regulated. While the Securities and Exchange Commission monitors the trading activities of all firms dealing in U.S. markets, the Federal Reserve, which regulates bank holding companies, has limited oversight powers over foreign firms. That means that while a foreign firm on Wall Street may be completely staffed by Americans executing U.S.-based transactions, if they are not a bank holding company, then their U.S. business can operate out of the view of the Feds. Does it really matter? It sure does. Foreign banks are critical to the U.S. funding markets. In fact, the failure of a major foreign financial firm on the Street could create a wave of destruction as great, if not greater, than if the firm was technically “American.” That explains why the U.S. government needed to bail out several foreign banks to the tune of around $600 billion during the financial crisis, which was roughly the same amount that was given to U.S. banks during that time. In addition, the Fed helped ease the situation by offering large dollar lines of credit to make sure that foreign banks had enough cash necessary to trade. The financial crisis revealed a gaping hole in U.S. regulation, one that the Fed wanted closed. The Dodd-Frank financial regulatory bill sought to to this by giving the Fed greater power to regulate the subsidiaries of foreign banking giants operating on Wall Street. But while the foreign banks were happy to take bailout cash and have access to cheap dollar funding from the U.S. government, they weren’t so keen on having another set of eyes peering over their shoulder. And they certainly didn’t want to be subject to the new capital restrictions and other regulatory restrictions that have come about under Dodd Frank. MORE: How to really stop (some) insider trading Deutsche Bank DB and Barclays have done their best to avoid being caught up in the Dodd-Frank regulatory net, going so far as to change the corporate structure of their U.S. subsidiaries specifically to avoid it. It seemed for a while that they may have gotten a pass, but the Fed last week announced that they wouldn’t get away with it. “We need to adjust the regulatory requirements for foreign banks in response to changes in the nature of their activities in the United States, the risks attendant to those changes, and instructions from Congress in new statutory provisions,” Daniel K. Tarullo, one of the governors of the Federal Reserve, said at the Yale School of Management Leaders Forum in New Haven, Connecticut last week. “The modified regime should counteract the risks posed to U.S. financial stability by the activities of foreign banking organizations, as manifested in the years leading up to, and through, the financial crisis.” The Fed for now seems to be targeting the big foreign banks, those that they consider to be “systemically important firms,” namely Deutsche Bank, Credit Suisse, UBS and Barclays. Tarullo said that the “a more uniform structure” is needed to match up oversight of the U.S. banks. They would include meeting stress test requirements, risk management requirements, single counterparty credit limits and early remediation requirements. In order to meet “stress test requirements,” banks need to adjust their capital ratios based on the amount of risk they take. That basically means that they need to have enough cash on hand – U.S. dollars – to fully fund their operations during a crisis. This cash can’t be held at the parent level, but at the subsidiary level in order to ensure that it will be there in the case of an emergency. MORE: BlackRock’s new bond plan It is here where things get pretty hairy for some of the banks. UBS and Credit Suisse won’t have much of a problem in this department because both have made it a point to raise enough capital since the crisis to replenish their reserves, both at the country and at the subsidiary level. Barclays and Deutsche seem to be the most affected, with Deutsche being the worst off. Barclays would need to transfer 5 billion pounds ($8 billion), equal to 11% of its tangible book value, to its U.S. subsidiary to meet U.S. capital requirements, according to an analysis by Autonomous Research Group. That is assuming the subsidiary is allowed to operate at 20 times leverage with a leverage ratio of 5%. If a more conservative 15 times leverage is prescribed to its European operations, Barclays would need to set aside another 4 billion pounds to 9 billion pounds ($14.5 billion). Deutsche would need to move an estimated 14 billion euros ($19 billion — equal to a whopping 1/3 of its tangible book value) into the U.S., according to Autonomous. If it did this then its leverage ratio outside the U.S. would be a heady 36 times leverage, putting it in Lehman Brothers leverage territory (dangerously high). Under the more conservative scenario the firm would have to put aside an additional 5 billion euros for total of 19 billion euros ($25 billion). It is doubtful that German regulators would allow Deutsche to maintain such a high leverage ratio or allow such a large transfer of capital out of Germany and into the U.S. So, in order to maintain their U.S. operations, Deutsche and Barclays will face some tough choices. Their first option would be to raise capital specifically for their U.S. units, most likely through the sale of new shares to investors, similar to the capital raising undergone by their Swiss counterparts over the years. But doing so would hit their stock prices hard as it would dilute the value of their shares in a big way. The second, and more practical, solution would be for them to reduce their U.S. asset holdings to bring them more in line with that of their parents. That would involve the sale of billions of dollars of assets. MORE: Costco’s odd fiscal cliff dividend deal A third and more radical option would be to exit the U.S. market. If the amount of money needed to meet the Fed’s capital requirement’s outweigh the benefits gained, the banks will have no choice but to sell or significantly curtail their U.S. operations. Completely spinning off the unit here would be no good as the independent subsidiary would still need to raise boatloads of cash to meet U.S. capital standards. Regulation continues to be the big unknown on Wall Street, namely, which rules will be implemented and when. But while the rule-making machine has stalled in the SEC and CFTC, the Fed is determined to carve out and protect its newfound powers under the bill. While banks should be held to a high standard when it comes to capital requirements, forcing a subsidiary to follow suit may not be as practical, even if it is staffed and run like a standalone domestic entity. Foreign subsidiaries don’t have the commercial bank deposits that domestic institutions like JP Morgan JPM and Citigroup C use to make their overall leverage ratios more palatable to regulators. Dodd-Frank gave the banks a long lead time to comply with the capital rules – as long as five years, so that is plenty of time for the banks to sell assets and slim down. But even after the slim down, it is still questionable as to whether foreign firms can maintain their heft on Wall Street after the Fed pays them a visit.