BPInsights: December 3, 2022

Stories Driving the Week

The Flaming FTX Fiasco and Its Fallout

CoinDesk op-ed this week lays bare the core issue behind FTX’s collapse, which its author says mainstream news outlets have obfuscated: “the misuse of customer funds,” as opposed to a bank run or a run on deposits. The piece, entitled “FTX’s Collapse Was a Crime, Not an Accident,” also criticizes the comparison of the FTX downfall to a traditional banking crisis. “FTX and other crypto exchanges are not banks” and do not do bank-style lending, so even a surge of withdrawals should not create a liquidity crunch, author David Z. Morris writes. In fact, FTX had promised customers it would never lend out or otherwise use the crypto they entrusted to it. “In reality, the funds were sent to the intimately linked trading firm Alameda Research, where they were, it seems, simply gambled away,” Morris writes. “This is, in the simplest terms, theft at a nearly unprecedented scale.”

Toxic ties: The close linkage between FTX and Alameda is at the heart of Bankman-Fried’s fraud, Morris says. FTX allegedly funneled money to hedge fund Alameda for trading, lending and investing, and now billions of dollars in customer funds have disappeared. Alameda also had a “secret exemption” from FTX’s liquidation and margin trading rules, according to CoinDesk. “Rather than the even playing field an exchange is meant to be, it was a barrel full of customers,” Morris writes. “Above them all, with shotgun poised, was Alameda Research.” Alameda may also have benefited from insider access to FTX’s token listing plans, which could result in an insider trading case, the CoinDesk piece says. “If these claims prove out, they would be perhaps the most obviously and brazenly criminal of the reported hanky-panky between Alameda and FTX.” The piece also reports large personal loans from Alameda to key executives.

Bank stake: Alameda’s stake in Farmington State Bank (doing business as Moonstone Bank), a tiny bank in Washington state, raises the specter of a crumbling offshore crypto giant with a toehold in the banking system. “In the broader context of the FTX story, the bank stake goes from ‘questionably legal’ to ‘incredibly ominous’,” the CoinDesk article notes. Alameda’s stake was just under 10 percent, the threshold for regulatory approval, according to a column by American Banker’s John Heltman. Moonstone appeared to be an aspiring crypto conduit into the regulated banking system.

“If this episode of the FTX saga means anything, it is that at least one crypto firm — that we know of — was sniffing around the perimeter of the banking system for some unknown reason,” Heltman writes. The CoinDesk piece likens the investment to attempted purchases of U.S. banks by Pakistan’s Bank for Credit and Commerce International, which wanted to expand its global criminal money laundering empire. To be sure, there is no evidence at this time of any wrongdoing related to Moonstone. But the prospect of FTX secretly gaining access to Fed accounts or other banking-system features raises serious policy questions that merit thorough and thoughtful inquiry.

SBF speaks: Bankman-Fried said he “didn’t knowingly commingle funds” in an interview with Andrew Ross Sorkin at the New York Times DealBook Summit this week. He also said he bears responsibility for “huge management failures” at FTX and that “we messed up big.” To read the full interview transcript, click here.

Fed Governor Cook: System Has ‘Adequate Capital’; New Regulation for Crypto May Be Unnecessary

Federal Reserve Governor Lisa Cook noted at a recent event that the financial system remained resilient during the pandemic. “The financial system has held up. It held up during the pandemic recession. That was because of the Fed acting extremely quickly, having learned something from the … great financial crisis,” she said, according to American Banker. “There is adequate capital in the system and I think this is something that the Federal Reserve is satisfied with.” She also said the financial system’s lack of damage from the crypto crisis demonstrates that banking examinations have done their job, and that a variety of new crypto rules might not be necessary. “Because we haven’t seen the crypto crisis lead, thus far, to a financial crisis, that says that the regular banking regulations — regular examinations, examiners asking questions about this potential intersection between crypto and banking activities — those actually have stood up,” Cook said. “So … we may not need a lot more different types of regulation. Maybe we just need to do the job that is already within our power to do.”

BPI on Vice Chair Barr’s Speech: High Capital Requirements Can Come With High Costs, and Policymakers Should Consider Them 

Federal Reserve Vice Chair for Supervision Michael Barr this week offered his views on capital regulation in a speech at an American Enterprise Institute event. He said “figuring out the right level of capital requires one to be humble and skeptical.” Barr is currently conducting a holistic review of the capital framework and working to shape the U.S. iteration of the Basel III Endgame changes. bank capital is already high enough, and said that interventions by the Fed, Congress and the Administration meant that the system didn’t get a “real test of resilience.” Barr also noted that while estimates of optimal capital vary widely and depend importantly on assumptions made, current U.S. capital requirements “are toward the low end of the range described in most of the research literature.”

Among his other remarks, he mentioned that “some have indicated that the leverage requirement for large banks is overly binding and may contribute to lower liquidity in Treasury markets, especially in stressed scenarios. We are exploring the empirical evidence and examining whether adjustments to the leverage ratio might be appropriate in the context of our holistic capital review, as well as in the context of broader reforms being undertaken by the Federal Reserve and a range of other agencies.”  Regarding stress testing, Barr stated they are “evaluating whether the supervisory stress test that is used to set capital requirements for large banks reflects an appropriately wide range of risks” and considering “[u]sing multiple scenarios or adapting the stress test in other ways to better account for the high degree of interconnectedness between banks and other financial entities.” Finally, in Q&A Barr noted that the Fed is also looking at the countercyclical capital buffer and will have more to say on this topic early next year.

  • BPI response: Francisco Covas, BPI executive vice president and head of research, responded Thursday to Barr’s remarks in a statement. While Vice Chairman Barr is taking a thoughtful approach, “we worry he is overly focused on the cost of calibrating capital requirements too low, as he makes little to no mention of the costs of calibrating capital requirements too high. Further increasing bank capital requirements will reduce U.S. economic growth, further diminish capital markets liquidity, push more activity into the unregulated shadow banking sector and further disincentivize bank lending to small businesses and low- to moderate-income households.”
  • Basel: To learn more about how Basel shapes the cost of capital through a unique process with limited transparency, read BPI’s recent post here.

Against What Liquidity Risks should a Bank Self-insure?

One of the defining questions for a liquidity regulation is: “Against what liquidity risks should a bank self-insure?” Self-insuring against a liquidity risk means having the resources to meet liquidity demands in a given situation, without making use of funding from the central bank.

In a new note, BPI Chief Economist Bill Nelson proposes a simple and reasonable way to incorporate access to regular central bank credit into liquidity assessments: In a scenario where a bank remains qualified for a specific type of central bank credit, the bank’s liquidity should be evaluated under the assumption that it will be able to use the credit on the terms the central bank is offering.

FDIC Nominees on the Hill: Key Takeaways

Three FDIC board nominees – current Acting Chairman Martin Gruenberg, a Democrat (for a new term as Chair), and Republican nominees Travis Hill (for Vice Chair) and Jonathan McKernan (for open board seat) – testified before the Senate Banking Committee at a nomination hearing on Wednesday. Here are key takeaways from their testimony.

  • Crypto: In response to Banking Committee Chairman Sherrod Brown (D-OH), Hill said “most of the public promise of crypto is for the future” and most crypto engagement today is speculative, although some crypto projects aim to make the financial system more efficient. But “as of today, most of that is theoretical and … not part of everyday life.” Brown referred to digital assets as risky and volatile and noted the sanctions evasion risk of crypto. Sen. Bob Menendez (D-NJ) also asked about crypto and how the nominees would ensure FDIC-supervised banks are “shielded from inappropriate risk” in that space. “There’s a big difference between a bank providing custody services for crypto-related activity versus a bank using its balance sheet to engage in speculative investments,” Hill said. McKernan noted that “there are some significant open questions as to what is a permissible activity when it comes to crypto at [banks], so I think that’s something I’d want to understand better.” He also said any crypto activities at an FDIC-supervised bank should be performed in a safe and sound manner; must comply with the law; and must not pose a risk to financial stability. Gruenberg told Sen. Jon Tester (D-MT) that the FDIC aims “to ensure we understand what we’re doing before we allow the insured banking institutions to get engaged in the activity.” Sen. Bill Hagerty (R-TN) questioned Gruenberg about the FDIC creating a precedent of seeking prior supervisory approval before institutions engage in activities like crypto.
  • Capital: Asked about capital requirements, Hill said “I don’t think there’s any downside to doing a holistic review” of the current requirements. Fed Vice Chair for Supervision Michael Barr is currently leading such a review, and the Basel III Endgame capital rulemaking process will involve all of the banking agencies.
  • CRA and financial inclusion: Hill noted in an exchange with Sen. Catherine Cortez Masto the work that the FDIC has done on Bank On products to promote financial inclusion. In a separate response to Cortez Masto on CRA, Hill said he wouldn’t prejudge details of the open rulemaking but committed to ensuring that the implementing rule fully achieves the statutory mandate. In response to Sen. Chris Van Hollen (D-MD), Gruenberg suggested that the CRA rulemaking could be completed early next year.
  • Transparency: Ranking Member Pat Toomey (R-PA) urged Gruenberg to commit to circulate FDIC meeting materials to board members at least two weeks prior to board meetings, in accordance with an internal FDIC policy. Gruenberg said he would commit to “doing our best on that.” Toomey and Sen. Thom Tillis (R-NC) also pressed Gruenberg on his role in the governance controversy that led to former Chairman Jelena McWilliams’ departure. Gruenberg agreed to provide details on the document at the center of that controversy to the committee as a follow-up.
  • Climate: Questioned by Toomey on the FDIC’s role in determining the pace of the transition to a lower-carbon economy, Gruenberg said “that’s not our responsibility.”
  • Rate cap: Asked by Sen. Jack Reed (D-RI) about a proposed 36 percent interest rate cap, Hill said “we always want to be careful on how we balance affordability with access to credit,” and added he would welcome the opportunity to take a look at Reed’s legislation and would implement it as required if passed.

The Crypto Ledger

The fallout of the FTX collapse continues to resonate throughout the crypto ecosystem, with BlockFi being the latest casualty, filing for bankruptcy this week as a result of its exposure to FTX and Genesis teetering on the edge of insolvency itself. The Senate Agriculture Committee also held a hearing this week on FTX featuring CFTC Chairman Rostin Behnam, who urged lawmakers to enact crypto legislation quickly. Here’s what else is new in crypto.

  • Kraken settles: Crypto exchange Kraken agreed to pay more than $360,000 to the U.S. Treasury Department to settle allegations of sanctions violations involving Iran transactions.
  • Tether red flags: The company behind stablecoin Tether has been increasingly lending its own coins to customers rather than selling them for hard currency up-front, according to a recent Wall Street Journal article. The trend increases the risk that the firm may not be able to pay redemptions in a crisis. If the collateral backing the loans is not liquid, the firm is vulnerable to a run.
  • ECB blog bearish on bitcoin: A blog post by ECB officials Ulrich Bindseil and Jürgen Schaaf expressed skepticism about the uses for bitcoin beyond speculation. Bitcoin’s fluctuation around $20,000 is likely “an artificially induced last gasp before the road to irrelevance – and this was already foreseeable before FTX went bust and sent the bitcoin price to well below USD16,000.” The blog post cites rare use of bitcoin in legal transactions and environmental impact. “Since Bitcoin appears to be neither suitable as a payment system nor as a form of investment, it should be treated as neither in regulatory terms and thus should not be legitimised,” the post says. (A disclaimer notes that the blog post represents the authors’ views and not necessarily those of the ECB and the Eurosystem.)

In Case You Missed It

Fed Staff Paper Sees Little First-Mover Advantage for CBDC

Moving fast on issuing a CBDC provides little advantage to central banks, a recent Federal Reserve staff paper says. “The first mover literature does not suggest that there is a compelling first-mover advantage for issuing a CBDC in the domestic payments market, reserve currency and international payments market, or payments technology market,” the paper says. “There is also unlikely to be a first-mover advantage for CBDC as an asset or as the potential foundation of a future financial state. Technology and markets are evolving quickly, which makes sustainable competitive advantage unlikely.” The paper’s conclusion appears to align with the Fed’s deliberate approach to considering a potential CBDC. “Rather than focusing on timing of entry, central banks may benefit more from identifying clear policy objectives, exploring technological designs, and understanding benefits and risks to inform any decision on CBDC issuance.”

OCC Updates Policy that Guides Decision-Making on Bank Fines

The OCC this week released a revised version of a manual — Policies and Procedures Manual 5000-7 — on civil monetary penalty (CMP) amounts, replacing a 2018 version.  The manual, and the “matrices” included therein, guide the OCC’s decision-making when assessing CMPs against banking institutions.  The revisions generally increase the maximum CMPs especially for the largest institutions but also contain new provisions designed to incentivize and reward self-disclosure and remediation (referred to as “mitigating factors”).  The prior version of the matrix included three mitigating factors: “good faith before notification”, “full cooperation after notification,” and “restitution, if applicable.”  The mitigating factors are now “self-identification”, “remediation/corrective action”, and “restitution, if applicable.”  The revised mitigating factors potentially have more weight in the CMP calculation.  However, the increased CMP maxima, especially for large banks, could often work in the opposite direction by increasing CMPs.  In addition, the manual now expressly calls for the OCC to consider pairing monetary penalties with business restrictions.  According to Acting Comptroller Michael Hsu, “The revised CMP matrix for OCC institutions will strengthen the effectiveness and fairness of our enforcement actions.”

New Wells Fargo Initiative With National Urban League Supports Diversity in Home Appraisal Industry

Wells Fargo and the National Urban League this week announced a $5 million grant to create the Diverse Appraiser Initiative, which aims to boost diversity and reduce barriers to entry in the home appraisal industry. The grant is expected to be allocated over five years with a goal of certifying up to 260 diverse appraisers.

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Disclaimer:

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.