BPInsights: December 2, 2023

A Basel Sticking Point: Op Risk

Federal Reserve Governor Christopher Waller said he would consider supporting the final Basel capital rule if the proposal’s operational risk element is revamped. “If there’s some willingness to move on operational risk and some other things, there is a possibility that this could be put forward in a revamped way that would be acceptable,” Waller said this week at an event at the American Enterprise Institute.

  • Op risk flaws: Operational risk events, such as cyberattacks or fraud, “are things that don’t typically occur at the same time as a financial meltdown due to a macroeconomic shock, so they’re not correlated with market risk, trading risk, all the other things that might bring a bank down,” Waller observed. Banks are already required to hold capital for operational risk through the stress tests.
  • Huge factor: It’s difficult to overstate the impact of the proposal’s operational risk charge on the overall capital framework and banking lines of business. It would act as a broad tax on everything banks do in the economy, and it accounts for nearly 90 percent of the increase in banks’ capital requirements under the Basel proposal. The proposed increase implies that the agencies believe banks are currently undercapitalizing for this risk, but research demonstrates that the proposed charge is excessive compared to actual operational risk losses. The op risk charge would decrease U.S. GDP by close to $90 billion each year.
  • Context: Waller is a crucial vote on the Federal Reserve Board given his dissent on the proposal. Both Chair Jerome Powell and Vice Chair for Supervision Michael Barr have indicated they are seeking broad consensus on the measure.

Five Key Things

1. New Resolution Rules for Larger Banks Should Be Tailored, Complementary

New resolution requirements under two banking agency proposals should be tailored to banks’ individual risk profiles as required by law, BPI said in two related comment letters. The requirements should also be harmonized to avoid duplication and inconsistencies. The letters are in response to the Fed and FDIC’s 165(d) proposed guidance, which would revise expectations for certain larger banks’ resolution plans, and the FDIC’s proposed resolution changes for insured depository institutions, or IDIs. 

“An ‘everything-all-at-once’ approach to bank resolution planning is counterproductive. To minimize costs to the financial system in a crisis, policymakers should embrace resolution rules that complement each other and enable banks to pursue the resolution path best suited to their business models. Without meaningful changes, these proposals risk inundating the agencies with extraneous information and distracting from core resolution capabilities, while also subverting the statutory obligation to tailor regulations to banks’ actual risk.” – Greg Baer, BPI President and CEO

In the letters, BPI recommends:

  • Tailoring: The 165(d) proposed guidance should continue to be tailored based on the risk a bank presents, accounting for the differences in business models and risk profiles between the very largest globally active banks and smaller institutions.
  • Optionality: The 165(d) proposed guidance should explicitly reaffirm that both single point of entry and multiple point of entry resolution strategies are viable options, and that banks should pursue the one that makes the most sense for their business. Pushing banks with less complex legal structures and business activities toward SPOE resolution would impose significant costs without corresponding benefits.
  • Interaction: The banking agencies should consider the interaction between the resolution planning proposals and the pending long-term debt proposal. Any long-term debt requirement should reflect a bank’s resolution strategy and avoid forcing a bank into a particular resolution method.
  • Need for coordination: The agencies should take a coordinated approach to the two sets of resolution planning requirements. The two frameworks should complement, rather than duplicate or contradict, one another. The FDIC’s IDI proposal should also be streamlined to avoid a constant churn of submissions, notices and other materials that detract from meaningful engagement between banks and regulators.
  • Clear expectations: The IDI rule should set clear expectations for banks. Clear and timely requirements and feedback would allow banks to manage their resolution planning more effectively.

BPI also submitted a joint letter this week with the ABA, IIB and SIFMA requesting an interim six-month extension of the July 1, 2024, submission date for filers subject to the proposed 165(d) guidance.

2. Assessment of the Fed’s Latest Supervision and Regulation Report – and Recommended Additions to Augment Future Reports

A new BPI blog highlights some key takeaways from the Federal Reserve’s most recent Supervision and Regulation Report and offers suggestions for making the reports more informative going forward.  The blog notes that the semi-annual reports are valuable for the insights they provide into trends and developments relating to U.S. bank holding company supervision, about which little other information is available to the public.

The latest Fed report concludes that the banking sector “remains sound overall”.  The BPI blog addresses key supervisory-related information included in the report and analyzes:

  • factors that contribute to the divergence in large banking organization vs. smaller banking organization examination ratings;
  • information presented in the report on outstanding MRAs and MRIAs at large banking organizations;
  • Federal Reserve supervisory priorities including contingency funding plans; and
  • increased Federal Reserve focus on supervision of interest rate and liquidity risk management.

The blog offers several suggestions to augment future Supervision and Regulation Reports.  At a high level these include:

  • Standardize and expand information on supervisory ratings to facilitate better understanding of trends and drivers.   
  • Include a breakdown of supervisory priorities at the supervisory program level. 
  • Provide for the larger bank categories the same detailed breakdown of supervisory findings that the report provides for smaller financial institutions.
  • Clarify the time frame covered by each report.
  • Disclose additional information on where and how the Fed examiner workforce is being assigned.
  • Include more detailed supervisory observations and findings (“lessons learned”) gleaned from the most recent standing and ad hoc horizontal examinations.

3. Former Vice Chair Quarles Breaks Down Basel Implications

Former Federal Reserve Vice Chair for Supervision Randy Quarles explained the consequences of the Basel proposal’s capital increases in a recent CNBC interview. Here are some key highlights.

  • Big-picture effects: The Fed is “requiring up to 20 percent more capital from the largest banks, which is a lot,” Quarles said in the interview. “And that will increase the capital costs of banking activity generally, and in particular, there are aspects of this proposal that would increase the capital cost of certain relatively safe fee-making businesses like wealth advice.” Fee-based lines of business are a way for banks to ensure steady revenue, but would be punished under the proposal.
  • Bottom line: The increased costs of higher capital “will reduce the financial system’s support for the real economy, at a time when many including me think that recession will be coming upon us as a result of monetary policy,” Quarles said.
  • Immediate effect: The proposal would be phased in gradually, but the market will anticipate the need for more required capital and “it will accelerate the period in which banks have to raise that capital, so you have the immediate contractionary effect, in addition to the financial stability effects that I think are negative by pushing activity out of the U.S. and out of the banking system.”
  • Outside the system: The “dramatic increase” in capital requirements will also drive activity out of the regulated banking system, Quarles noted. He also flagged the potential for mismatched capital requirements across global jurisdictions.

4. Data Sharing, Small Business Lending: CFPB’s Chopra on Capitol Hill 

CFPB Director Rohit Chopra testified on Capitol Hill this week at semiannual oversight hearings. Here are some key takeaways from the hearings.

  • Basel: Despite the CFPB not being involved in the Basel capital proposal, Chopra received a question about it at the Senate hearing because he voted on the proposal as an FDIC board member. The question illustrated the continuing pressure on Capitol Hill on policymakers to justify the economic costs of their proposed capital increases. Sen. Bill Hagerty (R-TN) asked Chopra about the proposal’s impact on credit availability for first-time and Black homebuyers. Chopra said “I can assure you I will personally look into that issue because [that’s] nothing I would want to see. I want our financial system working to serve everybody fairly.”
  • AI: Chopra warned at the Senate hearing about the risks of artificial intelligence in financial markets, saying it could cause flash crashes.
  • Small business lending data: House Financial Services Committee Chairman Patrick McHenry (R-NC) said the CFPB’s Section 1071 rule, which requires banks to gather data on small business lending, oversteps its statutory authority. The rule has garnered criticism over demographic questions, such as questions about borrowers’ race, that some observers find intrusive. The Senate recently voted to overturn the rule through the Congressional Review Act, and McHenry said House Republicans will also vote to do so.
  • Data sharing: McHenry said he sees “common ground” between the Bureau’s Section 1033 rule, which sets new standards for financial data sharing, and his Data Privacy Act legislation. “Americans should have greater control over their sensitive financial data,” McHenry said. He called the CFPB regulation “a good step” but said he would like to see a legislative change, too. “Like you mentioned, this rule is just one piece, but I think a legislative framework on privacy would be hugely valuable,” Chopra said.
  • Nonbank payment oversight: Rep. French Hill (R-AR) asked Chopra to clarify what firms are covered by the CFPB “large participants proposal” to oversee nonbanks with payment platforms and digital wallets. Hill asked if large retailers would be covered. Chopra did not answer definitively, but said, “if I were to speculate, and I’m just speculating, the most popular non-bank payment apps would be covered.” At the Senate hearing, Chopra said that for oversight of large tech companies and payment apps, “We are not expanding our authority. They are currently subject to our enforcement authority. And I think in our judgment, rather than resolving issues through litigation, we should look at those large firms serving tens of millions of people and make sure that they’re following the law, just like small banks are doing. Supervision of non-banks and banks is a key way that makes those laws consistently enforced.”
  • Cumulative cost: Rep. Bill Posey (R-FL) pressed Chopra on how the CFPB assesses the cumulative impact of its regulations on consumers’ access to credit.
  • Fees: Rep. Ann Wagner (R-MO) criticized the Bureau’s proposed substantial reduction of the credit card late fee safe harbor as amounting to a subsidy from “responsible cardholders who pay their bills on time, and typically never pay late fees” to “frequent late payers,” although Chopra denied that such a subsidy would occur. On the Senate side, Chopra said that the CFPB is “working on something” on overdraft practices to “address the harms while still allowing consumers to be able to access the liquidity when they have a shortfall.” 

5. Basel Sweep on Climate

The Basel Committee on Banking Supervision (BCBS) has published a consultation paper outlining its proposed approach for disclosure of risks under Pillar 3 of the Basel Framework. This follows the recent FSB report that claimed most banks have failed to provide meaningful climate disclosures. The disclosures proposed by BCBS are broad; they include Scope 3 standards; global geographical metric in various areas; and extensive scenario analysis forecasts. BCBS seeks comment by Feb. 29, 2024.

The paper follows the model set out for other areas by mandating both qualitative and quantitative disclosures and seeks feedback on:

  1. A proposed implementation deadline of Jan. 1, 2026, and potential transition periods.
  2. Proposed quantitative and qualitative data disclosure requirements, bank-specific metrics, forward-looking information forecasts and jurisdictional discretion regarding certain disclosure requirements.
  3. The various templates and approaches to disclosure included in the proposal. 

In Case You Missed It

Barr: Discount Window Readiness a Key Part of Banks’ Liquidity Toolkit

Banks should be prepared to borrow from the Fed’s discount window as part of a range of liquidity resources, and the turmoil this spring demonstrated the danger of being unprepared to use the window, Vice Chair for Supervision Michael Barr said Friday in a speech in Frankfurt. “It is crucial that banks have a diversified range of liquidity options that they are able to access in a variety of conditions,” Barr said. “And in the case of banks that are eligible to borrow from the Federal Reserve, discount window borrowing should be an important part of this mix.” Banks should be ready to borrow from the discount window in normal conditions and under stress, too, Barr said.

  • Fighting the stigma: Barr addressed the topic of discount window stigma. “Banks have previously said that they are afraid of receiving negative feedback from their supervisors in the event that their sole grounds for tapping the discount window is that it is the most convenient or cheapest form of funding immediately available to them,” he said. “In light of this, we at the Federal Reserve have been underlining the point to banks, supervisors, analysts, rating agencies, other market observers, and the public, through numerous channels, that using the discount window is not an action to be viewed negatively. Banks need to be ready and willing to use the discount window in good times and bad.”
  • Test run: Banks should test their discount window borrowing access to ensure they are ready to borrow in an emergency, Barr said. Pre-pledging collateral to the window is another aspect of ensuring that readiness, he noted.
  • Liquidity regulations: Liquidity measures like the LCR and NSFR have strengthened the banking system’s resilience, Barr said. However, he expressed that “these requirements may not, on their own, be sufficient to stem a rapid run. The speed of bank runs and the impediments to rapidly raising liquidity in private markets that may be needed in hours rather than days suggest it may be necessary to reexamine our requirements, including with respect to self-insurance standards and to discount window preparedness. The lessons from March also indicate that some forms of deposits, such as those from venture capital firms, high-net-worth individuals, crypto firms, and others, may be more prone to faster runs than previously assumed.”
  • Closer look: The Fed is studying what variations in discount window readiness among banks may mean for the financial system’s stability, he said.
  • Bank runs at sprint speed: The rapid run on deposits this spring has changed perceptions on the potential speed of bank runs, Barr said. “What occurred in two or three weeks or, in some cases, many months in previous episodes may, in the modern era, now occur in hours,” he said. “These issues are top of mind as we review and consider future adjustments to the way in which we should supervise and regulate liquidity risk.”
  • Questioning assumptions: Barr called previous assumptions on liquidity under stress into doubt. For example, he said banks may face difficulty selling assets quickly without attracting scrutiny from the market, and private repo markets could become volatile.

SEC’s In-House Courts Face SCOTUS Scrutiny

The SEC’s use of in-house judges in enforcement cases involving civil money penalties attracted skepticism from some Supreme Court justices this week during oral argument. Justice Brett Kavanaugh noted that officials who bring enforcement cases also appoint the in-house judges who decide them and then review the rulings, suggesting a lack of impartiality.

  • Background: The case, SEC v. Jarkesy, arose from the appeal of an SEC enforcement case against hedge fund founder George Jarkesy. The Fifth Circuit found that Congress violated defendants’ constitutional right to a jury trial by empowering the SEC to pursue civil penalties through certain administrative proceedings. Now the SEC’s use of in-house judges faces Supreme Court scrutiny.
  • Consequential case: The outcome of the case potentially has far-reaching implications, particularly for federal agencies – including banking regulators — that use administrative law judges in cases involving civil penalties.
  • BPI’s view: BPI, the American Bankers Association and the American Association of Bank Directors filed an amicus brief in the case urging the Supreme Court to uphold key aspects of the Fifth Circuit’s ruling. “Only then will bankers be assured that their property and livelihoods will not be stripped away via in-house enforcement proceedings where agency personnel, and not a jury of their peers, hold the ultimate reins of power,” the groups wrote. They emphasized that a decision on in-house judges is particularly important for banks because the banking agencies, unlike the SEC, are required to pursue any civil monetary penalties via in-house proceedings. “[U]nlike the Securities and Exchange Commission, the Banking Agencies lack statutory authorization to seek such penalties in court,” the brief said.

A Window Into Fed Lending

The Federal Reserve releases information on its discount window lending with a two-year lag, as required under the Dodd-Frank Act. A recent BPI research note delves into the most recent discount window data.

  • What is the discount window? The Federal Reserve’s discount window enables banks to borrow directly from the central bank to meet liquidity needs. Banks pledge assets as collateral for these loans, and they typically pre-pledge it in advance so they can borrow when needed. (The spring bank failures demonstrate the danger of banks being unprepared to borrow from the window.) There are three types of discount window loans: seasonal credit provided to small banks to meet seasonal needs; primary credit provided to financially sound banks on a no-questions-asked basis; and secondary credit which may be provided to banks that do not qualify for primary credit to help resolve financial difficulties.
  • Stigma: Ideally, the Fed’s discount window would be one tool out of many for banks to meet contingency liquidity needs, but it has suffered from stigma over the years – that is, when a bank borrows from the window, its examiners and investors assume it must be in trouble. This stigma is a key reason for the two-year lag in the data release.
  • What’s in the data? Each quarter, the Fed publishes data for the quarter two years prior. For each loan, the Fed provides the name of the borrower as well as the amount, type and interest rate of the loan. In addition, the Fed provides the total amount and type of collateral pledged by the institution backing the loan after the application of appropriate haircuts. For each loan entry, information on the lendable value of the entire amount of pledged collateral by type is reported.
  • The latest data: This note summarizes the data on collateral provided in the four most recent available quarters of data – 2020Q4 to 2021Q3. In total, the institutions that borrowed from the discount window over the four-quarter period had collateral prepositioned at the Fed with $917 billion in lendable value. A much higher percentage of larger banks borrowed at least once over the year than smaller banks, suggesting that larger banks are more likely to be prepared to borrow if necessary. Most loans were primary credit rather than the other types. And collateral varied — consumer loans and commercial loans made up the largest share of total collateral pledged for the banks in the relevant data set.

The Crypto Ledger

Binance is the latest crypto giant to experience a dramatic fall from grace. Its former CEO Changpeng Zhao pleaded guilty last week to anti-money laundering and U.S. sanctions violations under a recent settlement with the U.S. government. The settlement will allow Binance to continue operating, but the firm faces a $4.3 billion fine. Zhao stepped down as CEO as part of the agreement. Here’s what’s new in crypto.

  • Future of Binance: A Wall Street Journal piece this week questioned how Binance will function going forward in its “second act.”
  • SEC snares Kraken: The SEC last week charged Kraken for allegedly operating an unregistered securities exchange, broker, dealer and clearing agency. The platform is the latest major crypto player in the regulator’s sights.

‘Fighting Yesterday’s War’: Bank CEOs on Basel

Several bank chief executives expressed concern about the Basel capital proposal at a Financial Times conference this week. Here are some key quotes.

  • Yesterday’s war: The “U.S. Basel III proposals are actually fighting yesterday’s war”, UBS Chair Colm Kelleher said. “I think it’s clear that [regulators] did not follow due process in the quantitative impact study and feasibility studies and so on,” he said.
  • Disconnect: There’s a disconnect between the Basel proposal and regulators’ references to the spring bank failures, HSBC CEO Noel Quinn said. He noted “a bit of a disconnect in that argument because actually what happened earlier this year wasn’t about capital, it was about liquidity management.”
  • Huge liquidity impact: JPMorgan President Daniel Pinto warned that the changes could significantly affect liquidity in the financial system. “The top five market players in the world are American banks,” Pinto said. “If we all have to recalibrate, the impact on liquidity in the system will be huge.”
  • Higher airfare: In one example of the knock-on effects of capital increases, Goldman Sachs CEO David Solomon said travelers could face higher airfare costs as capital requirements drive up the cost of hedging fuel prices. He also said constraints on pension funds lending out securities could hurt returns for investors.

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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.