BPInsights: August 4, 2023

Are Basel Fed Board Strains a Warning Sign?

The divided Federal Reserve Board vote on the Basel proposal revealed significant tensions that could portend changes in the final rule, according to American Banker.

Dissents in the Fed and FDIC votes on the proposal, as well as concerns from non-dissenting members, could pressure policymakers to make changes in the final rule. Otherwise, a final rule could face pushback in Congress or the courts, the article suggested, leaving it vulnerable in the long term. “Whether that rationale and the agencies’ diligence in justifying this proposal is adequate is a question that I suspect will ultimately be decided by a judge,” American Banker Washington Bureau Chief John Heltman wrote in a recent column. “But I’m not even sure it will make it that far.”

• Fed doubts: The two Fed Board dissents – and concerns raised by Chair Jerome Powell and Governor Philip Jefferson, who voted to support issuing the proposal for comment – are particularly remarkable given the long history of policy consensus at the central bank. Jefferson, the nominee for Vice Chair of the Fed, expressed particular concern about how the proposal could affect bank lending. “I am also mindful of the proposals’ potential impact on the availability of credit to households and businesses and the ability of banking organizations to continue to provide liquidity in certain markets throughout the full course of the economic cycle,” Jefferson said at the Fed’s Board meeting.
• Showing their work: The proposal lacks the deep quantitative analysis of its impact that would typically accompany such a sweeping overhaul, lawyers and analysts noted in the news article by Kyle Campbell. “[T]he issues around data disclosures could prove to be more than gripes from unhappy bankers,” the article states. “They could be grounds for litigation,” an attorney said in the article. The Administrative Procedure Act requires regulators to give the public meaningful opportunity to comment on proposed rules, which includes the data and analysis underpinning a proposal.
• Broken promises: The attorney noted that a notable break from the Fed’s regulatory norms is “the decision to abandon the previous commitment to keep the implementation of the international regulations without changing the overall amount of capital in the banking system.”

Five Key Things

1. Does Central Bank Funding Belong in Bank Resolution Plans?

Bank failures this spring elicited new scrutiny of liquidity regulations and the Fed’s discount window. They revealed that some types of uninsured depositors can flee faster than previously assumed. And they raised two questions:

1. How can regulators raise deposit outflow assumptions in stress scenarios without making banks lend more to the government, instead of financing businesses and households? (Treasuries and reserves already make up more than 20 percent of bank balance sheets.)
2. Given SVB and Signature’s lack of preparation to borrow from the discount window – and the disastrous outcome – should regulators require banks to incorporate Fed funding sources into their contingency plans?

Most binding: For some large bank holding companies (the parent companies of commercial banks), the most binding liquidity requirements are those associated with resolution planning. It is necessary to increase the recognition of Fed contingency funding in resolution liquidity requirements, in order to avoid the pitfalls of simply raising deposit outflow rates in liquidity scenarios. This action would come with challenges because the Fed cannot and should not commit to lending to a failing bank. A new BPI note explores the circumstances under which banks could count on a greater role for the Fed lending to a bank that has been recapitalized at a healthy level under a resolution plan.

Bottom line: SVB and Signature Bank’s failures made clear that plans for potential bank failures and resolutions must adjust. That adjustment should include a recognition that certain uninsured depositors may rapidly flee a troubled bank. In making adjustments, policymakers should ensure banks can still provide ample credit to the U.S. economy, and that they are prepared to use the discount window in times of stress. Both these concerns would suggest that increasing the role of Fed contingency funding in resolution planning could be a productive step. A way to limit the risks of this expansion would be to apply such a change only to bank holding companies with credible resolution plans and with bank subsidiaries with committed liquidity facilities from the Fed. Doing so would increase banks’ preparedness to use the discount window in contingencies, especially if a CLF were a required component of a resolution plan, and allow banks to continue to devote most of their balance sheets to lending to businesses and households.

To learn more, click here.

2. Tech Firms Seeking Bank Charters: Update

Fintech firm Figure Technologies recently withdrew its bank charter application, according to the OCC. 

• Implications: The prospect of tech firms like Figure gaining access to the banking system’s benefits without all the regulatory obligations of a bank was alarming, both in terms of consumer protection and of regulatory arbitrage.  Figure had initially sought a bank charter to take only uninsured deposits, and later amended the application to indicate it might try to become insured.  Both plans appear to have sputtered.
• Meanwhile: Rakuten, another tech firm with onetime bank-lite aspirations, in May withdrew (again) its bid for an insured bank via an ILC charter. It’s unclear whether the firm, a Japanese marketplace akin to Amazon, will reapply, though it appears Rakuten’s current efforts are focused on obtaining a federal credit union charter – the company’s latest inappropriate play at regulatory arbitrage.

3. Federal Judge Partially Blocks CFPB Small-Business Data Rule

A federal judge in Texas this week partially blocked the implementation of the CFPB’s Section 1071 rule on small-business lending data collection as the CFPB awaits the outcome of a Supreme Court case on its funding structure. The preliminary injunction means that lenders that are members of two trades – the Texas Bankers Association and American Bankers Association — will not be required to comply with the rule while the Supreme Court weighs the funding case. Some lawmakers have criticized the small business rule as intrusive because of requirements for lenders to gather certain demographic data, such as information on small business borrowers’ race and ethnicity.

4. BPI’s Greg Baer Talks Capital on Penta Group Podcast

BPI President and CEO Greg Baer joined a Penta Group podcast this week to discuss major changes in bank capital requirements and their consequences. The proposed dramatic increase in capital requirements is misplaced given the tested resilience of the banks in question, Baer said. “This follows sort of a real-world test over the last 10, 15 years, where these banks really haven’t had problems, particularly around the risks that we’re talking about,” Baer said. “You saw Silicon Valley Bank, but that was a concern around interest rate risk and deposit concentration risk — two things that this accord does not look at at all. And the banks that are being subjected to this … uniformly did quite well, during that episode; some did extremely well. So it does seem like a non sequitur to any recent events and any past events.”

• Hard hit: Banks have not only weathered real stress tests like the pandemic, but they have also demonstrated in the Fed’s stress tests that they have more than enough capital — yet that is unmentioned in the Basel proposal, Baer said. “Banks operating in the United States — and that certainly includes foreign banks who provide a substantial amount of capital and are very hard hit by this proposal on both market risk and operational risk — they have all done very well, and they’ve done very well by the U.S. economy,” he said. “It is very difficult to understand.”
• Tailoring undoing: In proposing to reverse the tailoring changes under S.2155, the regulators have “effectively repealed that statute,” Baer said. “There’s basically nothing left.”
• Concern and confusion: “There usually isn’t much dissension on things like this at the [Federal Reserve] Board or at the FDIC,” Baer noted. “The fact that you saw two dissents each … and then you also saw expressions of concerns from the Chairman and with regard to certain issues with Governor Cook and Governor Jefferson. So I do think that sort of concern and confusion about why we’re doing this is probably widespread.”
• Escape clause: Basel “always has this sort of escape clause that says ‘this is the minimum standard; you can always do more,’” but if the U.S. is the only jurisdiction moving up in capital requirements, “you really don’t have global consistency.” It’s important to consider if the costs of capital charges are higher than the benefits, Baer said – the U.S. appears to be an outlier saying it wants business and consumer costs to be higher.
• Permanent effect: The proposal will permanently reduce GDP, jobs and economic growth, Baer said. And banks will likely adjust their balance sheets in response to the proposal by retreating from assets – such as certain loans – that yield the largest capital charges.

5. Liquidity Guidance Update Stops Short of Endorsing Discount Window

The federal banking agencies late last week released updated guidance on banks’ liquidity risks and contingency planning, encouraging them to be ready to use the Fed’s discount window. The lack of preparation to use the window was a factor that exacerbated SVB and Signature Bank’s chaotic failures. Federal Reserve Chair Jerome Powell recently said at an FOMC press conference that the central bank is looking to make the discount window less “clunky”. Nevertheless, the new guidance essentially repeats existing guidance.

• What the announcement didn’t include: What regulators said in the recent update is unremarkable – what’s remarkable is what they did not say. Credit unions with more than $250 million in assets are required to demonstrate access to the discount window or the credit-union equivalent. Why not commercial banks? And the agencies did not make any changes to the internal liquidity stress tests banks must regularly perform – including the discount window as part of these tests would make a meaningful difference in ending stigma.

In Case You Missed It

The Crypto Ledger

Crypto is illegal in China – but that hasn’t stopped the country from being Binance’s biggest market, according to the Wall Street Journal. Users in China traded $90 billion in crypto assets through the platform in a single month, according to the article. “Binance’s China footprint, previously undisclosed, offers a glimpse of how the crypto giant has managed to quietly operate on the fringes in places where it is, officially at least, unwelcome,” the article states. The crypto exchange is under intense regulatory scrutiny in the U.S., with pending SEC and CFTC cases and a DOJ probe. Here’s what else is new in crypto.

• Suspicious timing: Volumes of trade between the Russian ruble and the Tether stablecoin surged during the rebellion by the Wagner Group earlier this month, as Russians raced to find an alternative to the country’s weakening currency according to the Financial Times. The article also describes how dollar-pegged cryptocurrencies can provide an alternative to fiat currencies in sanctioned economies, such as Russia and North Korea, and for criminal actors and dark web operatives.
• SEC and Coinbase: The SEC requested Coinbase stop trading in all cryptocurrencies other than bitcoin before the agency sued the exchange, according to the Financial Times. Coinbase CEO Brian Armstrong said the company resisted the request and decided to take their chances in court as “delisting every asset other than bitcoin, which by the way is not what the law says, would have essentially meant the end of the crypto industry in the U.S.” SEC Chair Gary Gensler has argued that the majority of cryptocurrencies are securities and therefore fall under the agency’s jurisdiction.
• Ripple ruling rejected: A federal judge this week rejected the logic underpinning the recent Ripple case ruling, which had been the cryptocurrency industry’s biggest legal win to date. In a separate case, Judge Jed Rakoff of the Southern District of New York dismissed the notion that a crypto token’s sale only violates U.S. securities law when sold directly to institutional investors, a central premise of Judge Analisa Torres’ ruling in the Ripple case, also in the Southern District. Judge Rakoff ruled that the SEC’s case against Terraform Labs founder Do Kwon can move forward.

Fed Senior Loan Officer Survey Results Suggest Tight Credit Conditions

On Monday, the Fed released the results of its quarterly survey loans officers at large and medium-sized banks that it conducted in July (available here). The annual questions on the level of lending standards and the quarterly questions on the change in lending standards indicate that standards are at the tight end of the range seen since 2005 and getting tighter.  Banks reported that they tightened lending standards on business loans over the past quarter in large part because of a less favorable and more uncertain economic outlook.  Banks also reported that they anticipated tightening lending standards further in the rest of 2023.

Fed Senior Financial Officer Survey Results Suggest an Increased Demand for Reserve Balances

On Tuesday, the Fed released the results of a survey of senior financial officers at banks about their strategies and practices for managing reserve balances that it conducted in mid-May (available here).  In response to questions about funding strategies in the wake of March turmoil, half the respondents indicated that they increased FHLB borrowing, a similar fraction increased wholesale deposit rates; of those that take retail deposits, about half raised retail deposit rates.  Regarding reserve balances, about 40 percent raised their desired minimum level of reserve balances by more than 20 percent. 

Banks’ demand for reserve balances determines how long QT can continue, and these results suggest it can continue for a shorter period than had been thought.

Breeden Tapped as Deputy BoE Governor

Senior Bank of England official Sarah Breeden will lead the central bank’s financial stability work as the incoming deputy governor for financial stability, according to the FT. Breeden will start in the role in November, succeeding Jon Cunliffe. The move comes at a time of heightened attention to stability risks in the U.K. as the central bank has been battling inflation and rising rates have pressured the economy.

JPMorgan CEO Jamie Dimon: Capital Increases ‘Hugely Disappointing’

JPMorgan Chase chief executive Jamie Dimon joined CNBC on Wednesday, where he expressed consternation about regulators’ plans to drastically increase capital requirements. The proposed rise in capital requirements is “hugely disappointing,” Dimon said. He noted that the Basel proposal will make it more costly for banks to engage in mortgage and small business lending. He also discussed the dominance of nonbank lenders, private equity and hedge funds, which will likely benefit from the new proposed changes.

• Models: Dimon suggested the Federal Reserve should be mindful of blind spots in its models, and said they “lack transparency.”
• Real world impact: Dimon said policymakers should be open with the American public about the effects of the proposal. “[T]hey should tell the American public, when we do this, it is going to reduce mortgage affordability and raise the cost by X dollars – because that is exactly what it’s going to do,” he said. “I could say the same thing about small business and a bunch of other impacts.”
• Stress testing: JPMorgan does many stress tests every week, in contrast to the Fed’s annual exercise. “I’m far more worried about China and cyber than I am about that stress test,” he said.
• On recent banking turmoil and regulatory changes: “A lot of these folks are using every issue that takes place to justify what they already thought,” Dimon said. “The best advice I ever heard was ‘use your brains to figure out the truth not to justify what you already think.’”

BofA’s Moynihan on Capital, Fed Debate

Bank of America CEO Brian Moynihan discussed a range of economic topics, including capital, on Bloomberg TV on Thursday. Capital requirements constrain lending, he noted. He also observed that the banking system is coming from a place of strength. “This industry is well-capitalized; it just proved it again in another crisis,” he said. “It’s well-managed, it’s well-regulated.”

• Shadow banking: If capital requirements get too high it could “push stuff back outside the tent” of the banking system, he said.
• Dissent: The amount of dissent among Federal Reserve governors on the Basel proposal is highly unusual for the central bank, Moynihan said. “I’m surprised at the amount of dissent by the governors of the Federal Reserve,” he said. “There’s a lot of water that’s got to go over the dam here to get these rules right, because there’s a debate even among the governors themselves about what the right answer is.”
• Competitiveness: “This is making the bank industry, all banks, less competitive to midsize U.S. companies than foreign banks are to midsize U.S. companies participating in the same global supply chains in those countries,” he said. “They need to sort of come to a common agreement on Basel III across the world – we’re just applying it with much more rigidity and requirements.”
• Investor implications: Investors may hesitate to invest in U.S. banks if the “capital demands don’t stop,” Moynihan said.