BPInsights: April 13, 2024

Bank Capital Requirements and the Law: Takeaways from FedSoc Event

This week, the Federalist Society hosted a panel event examining the Basel capital proposal and the legal issues surrounding it. The panel was moderated by Gibson, Dunn & Crutcher partner Eugene Scalia. Panelists included Wharton Professor Peter Conti-Brown, BPI Senior Fellow Jeremy Newell, former Fed Vice Chair for Supervision Randy Quarles and Boyden Gray partner Trent McCotter. Here are some highlights.

  • Capital fallacy: Quarles disputed some prominent misconceptions, such as the notion that more capital is always preferable. “It is not true that if one pill is good, and two pills are better, that swallowing the whole bottle is best,” he noted. And on the notion of the capital increases being necessary because of last spring’s bank failures, he said, “That answer is so bad, it isn’t even wrong,” adding that SVB’s collapse centered on liquidity risk management issues and supervisory failures.
  • Legal problems: The panelists and moderator discussed the prospect of litigation against the banking agencies. Trent McCotter emphasized the importance of legal arguments around “non-delegation” – the principle that Congress cannot delegate its lawmaking ability to other entities. The topic is an important one for the current Supreme Court, he observed, and the banking agencies’ power to ensure “adequate” capital in the banking system gets to the heart of such topics. “[T]his sort of statute is one that’s ripe for challenge because of that multilayer delegation — relatively rare for agencies to have that kind of power, both broad power in the first place and then a broad power to redefine it,” McCotter said. “So it’s not so much of a leap, I think, if the Supreme Court reinvigorates non-delegation, that this kind of reg is one that could be in their crosshairs.” On the general recent trend of regulated industries challenging regulations in court, McCotter said: “There’s a reason people keep raising these challenges now, which is that broad, vague statutes tend to breed bad regulations, and people challenge bad regulations and will use the options they have at hand.” The Fed has ample data at its disposal about different kinds of bank risks and asset types and would be expected to use it when overhauling capital requirements, but “the basic problem with the proposal is that it doesn’t do any such thing,” BPI’s Newell said. The courts have long held that the Administrative Procedure Act “requires that agencies do their homework and show their work,” he said. “And I just think that the proposal falls well short of that bar, and frankly, needs to be reproposed.”
  • Process: Quarles laid out the norm of consensus-building in decision-making at the Fed, and said “This proposal clearly did not have broad support … the process has damaged the Fed’s reputation for impartiality, for analysis and for fairness.”
  • The debate: Conti-Brown drew a distinction between regulation and supervision and said that “what this speaks to is a supervisory engagement,” and determining what is an adequately capitalized bank is “indeed a discretionary judgment.” Newell observed that, in recent years, many things traditionally left to the supervisory process “have increasingly become the subject of bright-line legislative rules, whether that’s more detailed capital requirements, liquidity requirements and so on.” The positive aspect of that trend is more transparency and public input on important policy choices, Newell said. One of the issues with this proposal is the banking agencies approach it through a supervisory lens, proceeding as though they have “no real burden of public transparency or accountability. And so certainly, to me, that sort of supervisory, decision-by-fiat approach is something that I see inflected in in the proposal and the way that it completely overhauls risk weights without, again, any discussion of the actual data and evidence that’s available.”
  • Missing the point: One of the “great ironies” with the proposal is that the point of the Basel III Endgame exercise was to retain a crucial part of the bank capital framework where banks could use their internal models for credit risk, but with added guardrails around those models, Newell said. The U.S. banking agencies have proposed to eliminate both the requirement and the option to use those internal models.

Five Key Things

1. Bowman: Capital Rule May Need to Deviate from Basel

Federal Reserve Governor Michelle Bowman said this week that the U.S. may need to diverge from the international Basel standards to address distinctive aspects of the U.S. banking system. “Just like in the U.K. and in the EU, the U.S. proposal may need to deviate from the Basel standards to address unique characteristics of the U.S. banking system,” Bowman said, “which is entirely appropriate based on these differences.”

  • Context: The U.S. proposal has certainly deviated from the 2017 Basel agreement, but has done so by tacking on arbitrary surcharges on top of Basel’s risk weights. Bowman alluded to this issue in comments this week, noting that “overcalibration” was a challenge with the proposal, which goes “beyond the Basel agreement.”
  • Broad consensus: Echoing language from Chair Jerome Powell, Bowman said that the U.S. agencies’ goal for the Basel proposal should be “a revised rulemaking that can achieve broad consensus.”

2. Senators Aim to Overturn CFPB Late Fee Rule

A group of Republican senators led by Banking Committee Ranking Member Tim Scott (R-SC) introduced legislation this week to overturn the CFPB’s rule lowering the safe harbor on credit card late fees to $8. The measure aims to invalidate the rule under the Congressional Review Act. BPI and a coalition of trades expressed support for the bill.

  • Background: The CFPB rule would reduce the availability and raise the cost of credit card products, particularly for lower-income individuals. It would also eliminate incentives to pay on time, potentially lowering consumers’ credit scores. “While Americans struggle to keep pace with record inflation under President Biden, now is the wrong time to play political games that limit access to credit,” Scott said in a statement. “But that’s exactly what the CFPB’s rule to limit credit card late penalties will do – it will decrease the availability of credit card products and important financial services, particularly for Americans who need them most. Lawful and contractually agreed upon payment incentives promote financial discipline and responsibility, and this rule shows that the CFPB is more focused on scoring political talking points than policies that protect consumers.”
  • Next steps: Rep. Andy Barr (R-KY) is spearheading the companion late fee CRA in the House and the House Financial Services Committee plans to mark it up on April 17.

3. Appeals Court: CFPB Lawsuit Should Stay in Texas

The U.S. Court of Appeals for the Fifth Circuit blocked a lower court decision to transfer a legal challenge of the CFPB’s credit card late fee rule to a court in Washington, D.C. The Fifth Circuit ordered the lower court to reopen the case in Texas and to tell the District Court in D.C. that the transfer was void. Judge Don Willett ruled that Judge Mark Pittman lacked the authority to transfer the case. Judge Andrew Oldham also concluded that Pittman had improperly moved the case and misapplied the standards for case transfers.  Judge Pittman complied with the Fifth Circuit’s order and reopened the case, while Judge Jackson in D.C. District Court issued an order terminating the case in that venue.

4. Deposit-Shuffling is a Sticky Business

During the midsized bank turmoil in spring 2023, the private equity-owned firm IntraFi found an important niche, as reported by Semafor in a recent article. IntraFi splits big customer deposits across banks (these deposits are known as reciprocal deposits) to keep each individual account under the $250,000 FDIC insurance limit. It runs a deposit marketplace where it brokers deposits between banks that want to buy and need to sell them. The company’s revenue climbed 62 percent last year amidst the 2023 banking turmoil.

  • How it works: “IntraFi is essentially selling insurance above and beyond what the FDIC offers,” Semafor’s Liz Hoffman writes. “But it’s a weird insurance policy. IntraFi doesn’t pay out in the event of a failure. The fees it collects aren’t policy premiums that are pooled and invested conservatively to cover future payouts. They’re profits, collected by two private-equity firms.”

5. FDIC Lays Out GSIB Resolution Process

The FDIC this week published a paper outlining the resolution process for U.S. Global Systemically Important Banks, which is governed by Title II of the Dodd-Frank Act. The paper detailed the operational steps the FDIC would take in such a situation, such as launching the resolution and stabilizing the firm’s operations. The release was accompanied by a speech at the Peterson Institute by Chair Martin Gruenberg, who emphasized he is confident that a GSIB could be resolved if necessary. “We believe we have the authorities, resources, and capabilities to do the job if it becomes necessary,” he said.

  • Notable contrast: The approach to resolution discussed in the paper is distinct from the resolution of Silicon Valley Bank last year, which still lacks meaningful accountability. SVB’s resolution took place under different circumstances, as it was not a GSIB, but the FDIC’s performance in the resolution raised concerns about its capability to wind down large banks in an orderly fashion. Questions remain about the FDIC’s handling of the resolution, including how the agency conducted its auction of the failed bank and how it has managed the receivership. The public would benefit from these questions being answered.

In Case You Missed It

Financial Data Privacy Bill Could Be Attached to Broader Privacy Legislation

Financial data privacy legislation by House Financial Services Committee Chair Patrick McHenry (R-NC) could become part of a bipartisan data privacy bill unveiled last weekend, according to POLITICO. McHenry has emphasized the financial privacy bill as one of his top legislative priorities before his upcoming retirement and identified the broader privacy package as a potential vehicle to move his legislation. McHenry’s bill would amend the Gramm-Leach-Bliley Act of 1999, which governs financial data privacy. It is still unclear whether the current data privacy bill, spearheaded by Rep. Cathy McMorris Rodgers (R-WA) and Sen. Maria Cantwell (D-WA), would be referred to the House Financial Services Committee.

Navigating Artificial Intelligence in Banking

Artificial intelligence is forcing companies and governments to consider how these new tools and innovations can benefit, and potentially harm, society. However, AI and its many adaptations have been around since at least the 1940s, and as such, many safeguards are already in place that can enable responsible AI adoption.

A new BPI working paper examines the regulatory frameworks governing the responsible use of AI in the financial sector that regulators and financiers must consider. It also spotlights applications for AI in banking, including fraud detection, cybersecurity, customer service (such as chatbots) and automated digital investment advising.

The core findings:

  • Banks are better prepared than most industries to innovate with AI. Financial institutions are one of the most regulated sectors of the economy. Laws and regulations are already in place to govern risk and how financial data can be securely used, shared and stored.
  • Not all risks (or institutions) are alike. Policymakers recognize the folly of one-size-fits-all strategies; strict compliance regimes reduce efficiency and discourage innovation by forcing institutions into a check-the-box compliance regime, oftentimes to the disadvantage of smaller institutions with fewer resources. Instead, the regulation of activities should be based on evaluating risk and encouraging a commensurate and bespoke response.
  • AI is instrumental in preempting cybersecurity and illicit finance threats. Criminals and hostile nation-states are relying on AI to commit more frequent and sophisticated attacks on America’s financial system. Banks must leverage every tool at their disposal to mitigate these risks and maintain a competitive advantage. AI is instrumental in meeting these demands.
  • Safe and sound adoption of AI is in everyone’s interest. Banks and regulators share the mutual goal of a safe and sound financial system. The private sector is committed to collaborating with regulators as the field of AI evolves, especially in four key areas:
    1. The explainability of AI models;
    2. Managing third-party risk;
    3. Validating models; and
    4. Calibrating regulation to future AI use cases.

The bottom line: Banks are effectively positioned to embrace AI innovation based on existing regulation and risk-management frameworks. Banks and regulators should continue to collaborate to safely harness the power of AI for the benefit of consumers and the American economy.

Bank Rules, Global Wars and Humility: Excerpts from Jamie Dimon’s Shareholder Letter

Here are a few noteworthy highlights from JPMorgan Chase CEO Jamie Dimon’s annual shareholder letter, released this week. At a high level, Dimon raised concerns about potential economic headwinds, such as geopolitical risks from global conflicts. He also laid out challenges in the bank regulatory system.

  • Unintended consequences: Dimon called for a hard look at the panoply of banking regulations and requirements put in place since Dodd-Frank. “It would probably be an understatement to say that some are duplicative, inconsistent, procyclical, contradictory, extremely costly, and unnecessarily painful for both banks and regulators,” he wrote. “Many of the rules have unintended consequences that are not desirable and have negative impacts, such as increasing the cost of credit for consumers (hurting lower-income Americans the most).”
  • Basel Endgame risks: Dimon expressed several concerns about the Basel capital proposal, which he said would “hamper American banks” in international competition. The analysis of the rule’s effects should have been undertaken before the proposed rulemaking, he noted. The rule “punishes consolidation and diversification,” in contrast to the takeaway from the Global Financial Crisis that diversified, well-managed banks are valuable. Dimon also observed that the framework is duplicative and the new proposed rules do nothing to fix what caused last spring’s bank failures. Ultimately, the Basel proposal will likely increase costs for all market participants and activity, including loans, market making and hedging, he said.
  • Liquidity: In liquidity regulation, rules should recognize the value and importance of lending and borrowing against good collateral, as well as using central bank resources like the discount window. Tying up good liquidity, a pitfall of current liquidity requirements, makes the system more fragile, he said.
  • Potential benefits: Banks and regulators can collaborate to improve the banking system, Dimon suggested, such as by redirecting resources to addressing urgent risks like China and cybersecurity; favoring nimble risk analysis over rigid processes; and examining unappreciated risks outside the regulatory system. Other improvements could include how the FDIC manages failing banks and how liquidity requirements can create more flexible funding for banks under stress.
  • Key quote: Dimon’s letter also offered lessons learned on management and decision-making. “Curiosity is a form of humility — acknowledging that you don’t know everything. Responding to curiosity allows other people to speak freely. Facts and details matter and inform a deeper and deeper analysis that allows you to continually revise and update your plans. This, of course, also means that you are constantly admitting prior mistakes.”

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The views expressed do not necessarily reflect those of the Bank Policy Institute’s member banks, and are not intended to be, and should not be construed as, legal advice of any kind.