BPInsights: April 8, 2023

Tailoring Gave the Fed Tools on SVB

Last week’s congressional oversight hearings surfaced some confusion over whether the Federal Reserve had the authority and discretion to apply enhanced prudential standards to Silicon Valley Bank under the 2018 regulatory tailoring law. The answer is a clear “yes”: The Fed did have the authority to do so. As soon as early 2021, the Fed could have issued an order directing SVB to meet more stringent regulatory requirements.

  • The law is clear: The Fed could have applied enhanced prudential standards to SVB after it crossed the $100 billion asset threshold. To take this step, it only needed to meet two basic criteria: determining that applying those rules was appropriate to promote SVB’s safety and soundness or mitigate financial stability risks, and taking into consideration SVB’s unique risk profile and business model. Both these criteria appear to have been satisfied.
  • Bottom line: The question then is why the Fed didn’t enhance the standards for SVB in light of its rapid asset growth, unique business model, reliance on uninsured deposits and significant liquidity and interest rate risk profile. There’s no question that it certainly could have.

Five Key Things

1. Small Banks See Deposits Inflows

According to Fed data released on Friday, April 7, commercial bank deposits in the U.S. increased by $43 billion in the week ending March 29, compared to a decrease of $179 billion in the prior week. While loan balances remained relatively unchanged, loan balances held by small banks continued to decline.

  • Small banks: Deposits at small U.S. banks, which had experienced significant outflows in the wake of recent bank failures, increased by $26 billion in the week ending March 29. Small bank deposits had dropped by $185 billion the week of the SVB failure (week ending March 15). The latest data show deposits inflows at small banks.
  • Large banks: Deposits at large banks rose by $50 billion in the week ending March 29.
  • Loans: Loan balances at large banks increased by $20 billion, but loans held by small banks declined more than $50 billion between March 15 and March 29.

2. Ensuring Clarity on What’s Insured: FDIC Should Avoid Prescriptive Approach

The FDIC’s proposal to modernize its sign and advertising rules is welcome, but a less prescriptive approach would allow banks to more effectively communicate to customers which bank products are FDIC-insured and which are not, the Bank Policy Institute and American Bankers Association said in a comment letter this week. An overly prescriptive approach may undermine that goal.

The challenge: While the FDIC’s proposed requirements rightly aim to prevent misleading or confusing customers about the insured status of banking products, certain aspects of the proposal are overly prescriptive, which may unfortunately make the customer experience more confusing. For example, the proposal would require banks to display the FDIC sign on landing dashboards for customers’ accounts, which could mislead the customer into thinking that all the accounts referenced via the dashboard — including non-deposit accounts, such as investment accounts — are FDIC-insured.

What BPI and ABA are saying: “Consumers need clarity on which financial products come with the benefit of FDIC insurance,” the associations said. “Today’s bank customers have more choices than ever on where to obtain financial products and services, and they should be armed with clear information to enable them to choose among products that best suit their banking needs – however, the prescriptive approach outlined in the FDIC’s proposal could make the customer experience more confusing than informative. Modernized FDIC rules should allow banks flexibility to provide clear and conspicuous disclosures that align with the modern ways that banks reach their customers.”

To learn more, read the letter here.

3. Bipartisan Group of Lawmakers Warns of ‘Escape Hatch’ in Proposed FinCEN Form

A bipartisan group of members of Congress led by House Financial Services Committee Chairman Patrick McHenry (R-NC) and Sen. Sheldon Whitehouse (D-RI) cautioned senior Treasury officials about gaps in a proposed anti-money laundering reporting form that could degrade the benefits of the forthcoming FinCEN beneficial ownership registry and provide an opportunity for financial criminals to seek to evade scrutiny. In a letter this week to Treasury Secretary Janet Yellen and FinCEN Acting Director Himamauli Das, the lawmakers expressed concern about FinCEN’s proposed reporting form for its beneficial ownership database, a directory of business owner information that is meant to be a key tool for preventing anonymous shell companies.

  • Key quote: “The agency made the conscious decision to craft the Notice with an ‘escape hatch,’” the lawmakers said. “Specifically, allowing ‘Unable to identify…unable to obtain’ or ‘Unknown…not able to obtain’ determinations undermine the effectiveness of the law. The statute provides straightforward, easy-to-understand reporting parameters that do not allow a reporting company to offer such responses.” BPI has also called on FinCEN to adjust the form to prevent companies from inappropriately omitting data.
  • Pending updates: The Wall Street Journal recently reported that FinCEN is considering updates to the form that would make clear that reporting companies must submit complete and accurate information about their owners.

4. NY Fed Releases Climate Risk Staff Reports

The Federal Reserve Bank of New York this week published two staff reports on climate risk. One report covered climate stress testing, while the other focused on U.S. banks’ exposures to climate transition risks.

Stress testing: The climate stress testing report explored the design of climate stress tests and scenarios used by regulators. The authors highlight the need to consider many transition risks as dynamic policy choices; understand and incorporate feedback loops between climate change and the economy; and explore scenarios where climate risks coincide with other risks. They contend that more research is required to “identify channels through which plausible scenarios can lead to meaningful short-run impact on credit risks, given typical bank loan maturities”, incorporate bank lending responses to climate risks, evaluate climate risk pricing in financial markets and take into account how expectations form around the realizations of climate risks. They also suggest ways to improve climate scenario modeling. The authors emphasize the “model risk” involved in projecting climate change in different scenarios and “mapping them into economic damages and bank loan loss or mark-to-market corrections”, and suggest complementing bottom-up stress tests with “top-down” approaches that better capture changing market expectations.

  • Regulation, supervision and capital: The climate stress testing report notes: “[R]esearch and policy need to better understand the implications of possible ‘green capital requirements’, which have been proposed by some regulators, on both carbon emissions and financial stability. More broadly, further work is required to better understand what policy, regulatory, and supervisory measures might be appropriate to build resilience against the consequences of climate-related financial risks.” The report indicates that such policy analysis is “particularly important since central banks will need to clearly communicate how any proposed policies are justified within their various mandates. However, even if specific interventions might not presently be within central bank mandates, the development of appropriate climate risk scenarios for stress testing purposes is likely to be still valuable.”  Worth noting: The Federal Reserve has emphasized that its climate scenario pilot will not have capital or supervisory implications; this report suggests that supervisory—if not regulatory—implications are likely to come in the future.
  • Timing mismatch: In the climate stress testing report, the authors note that “to the extent that many of the cash-flow implications of physical climate risk realizations are expected to materialize only at longer horizons … the effects of those risks on banks through their loan books may be limited.” Bank loans typically have shorter time horizons than the long horizons of climate scenarios, which sometimes span decades.
  • Nonbanks: Both reports suggest expanding research to analyze climate risk exposures among nonbanks such as asset managers and insurance companies.

Transition risks: The other report examines how climate transition risks – those arising from policy changes such as carbon taxes rather than directly from natural disasters or other tangible effects of climate change – affect bank loan books. The authors use model estimates from Jorgenson et al. (2018), Goulder and Hafstead (2018) and the Network for Greening the Financial System (2022a). The results show that “while banks’ exposures are meaningful, they are manageable.” Such exposures vary by model and policy scenario (some scenarios depict an “orderly” economic transition while others depict a disorderly one).

5. What’s Next for FDIC on SVB, Signature Loan Portfolios

The FDIC has tapped BlackRock’s advisory arm to help it sell $114 billion in securities left over from its takeover of SVB and Signature. The portfolios include mortgage-backed securities, collateralized mortgage obligations and commercial mortgage-backed securities, according to the FDIC. The FDIC said the sales would be “gradual and orderly” and will aim to minimize negative market impact. The agency has also hired Newmark, a commercial real estate advisory firm, to advise it on the sale of $60 billion in Signature loans, many of which were in commercial real estate.

In Case You Missed It

Banks Reluctant to Tap Liquidity Buffers, BoE Says

Banks hesitate to use their buffers of liquid assets under stress, fearing regulatory and market reactions, the Bank of England noted this week. Changes to regulations may be necessary to encourage banks to feel free to tap their liquidity reserves, the central bank said. The Bank of England pointed to the stockpiles required by the liquidity coverage ratio as buffers that banks are reluctant to draw on.

CFPB Lays Out ‘Abusiveness’ Interpretation in Policy Statement

The Dodd-Frank Act banned “abusive” conduct in consumer financial markets.  The CFPB this week released a policy statement setting out its interpretation of what constitutes prohibited “abusive acts or practices” in connection with the offering of a consumer financial product or service.  The statement describes the four forms of abusive conduct addressed in the Dodd-Frank Act:  (i) material interference with the ability of a consumer to understand a term or condition; (ii) taking unreasonable advantage of gaps in consumers’ understanding; (iii) taking unreasonable advantage of unequal bargaining power; and (iv) taking unreasonable advantage of consumers’ reliance on an entity to make a decision for them or advise them on a decision. It indicates that “abusiveness” requires no demonstration of substantial injury to establish liability, but is focused instead on conduct that Congress presumed to be harmful or distortionary to market functioning. The CFPB is requesting comment on the policy statement. Here are other takeaways about the statement:

  • Going further: This policy statement goes beyond the now-rescinded 2020 statement that expressed how the CFPB intended to exercise prosecutorial discretion – that 2020 statement suggested it would only pursue cases against firms that demonstrated a lack of good faith in their actions. That previous statement didn’t seek to summarize existing precedent on abusive acts or practices or provide a framework for identifying them. The new policy statement has a much more expansive view of what constitutes an abusive act or practice.
  • Self-referential: The precedent cited in this week’s policy statement largely consists of allegations included in complaints or pleadings filed by the CFPB rather than language from final judicial decisions.
  • Laying down a marker? According to CFPB Rohit Chopra, “The CFPB issued today’s guidance to provide an analytical framework to help federal and state agencies hold companies accountable when they violate the law”.  The CFPB seems to be laying down a marker through this policy statement for other enforcement agencies to follow when pursuing claims against financial institutions.

Key Economic Aides Leave Administration

Two senior economic officials departed the Biden Administration in recent weeks. Cecilia Rouse, former chair of the White House Council of Economic Advisers, left her position on March 31 to return to teaching at Princeton University. Ben Harris also left his Treasury Department position as assistant secretary for economic policy.

The Crypto Ledger

The Treasury Department this week released a report on the illicit finance risks of decentralized finance, or DeFi. The report recommended strengthening U.S. AML/CFT supervision, increasing regulatory scrutiny on digital currency firms and advocating for cyber resilience for digital asset firms. It also called for closing any gaps that may allow DeFi services to fall outside the Bank Secrecy Act’s definition of financial institutions. Here’s what else is new in crypto.

  • ‘Supervisable’: Crypto firms such as Binance claiming to have no headquarters must be “supervisable,” ECB supervisory board member Elizabeth McCaul said in a recent post. She called for stricter measures beyond the EU’s rulebooks for financial and crypto markets.
  • Challenging: Noah Perlman, Binance Holdings Ltd.’s new global chief compliance officer, expressed frustration at a recent crypto conference about the regulatory environment for crypto firms. He referred to his job as one of “the most challenging opportunities in compliance.” Binance faces a lawsuit from the CFTC.

Regulation, Geopolitics and the Future of Banking: What’s in Jamie Dimon’s Shareholder Letter

JPMorgan Chase CEO Jamie Dimon released his annual shareholder letter this week. Dimon offered takeaways on the SVB failure and subsequent stress. Dimon called for strengthening small and midsize banks, acknowledging the necessity of large, diversified banks and allowing market makers to intermediate. He also said “[r]egulation, particularly stress testing, should be more thoughtful and forward looking.” In addition, Dimon also offered big-picture thoughts on the future of the banking industry. While banks are playing a smaller role in the financial system than before, partly due to regulatory factors, they will continue to be “guardians of the financial system,” he wrote.

  • Key quote: “The debate should not always be about more or less regulation but about what mix of regulations will keep America’s banking system the best in the world, such as capital and leverage ratios, liquidity and what counts as liquidity, resolution rules, deposit insurance, securitization, stress testing, proper usage of the discount window, tailoring and other requirements (including potential requirements on shadow banks),” he said. “Because of the recent problems, we can add to this mix the review of concentrated customers, uninsured deposits and potential limitations on the use of HTM portfolios.”

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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.