BPInsights: December 9, 2023

At Senate Hearing, Basel Endgame is the Star Witness

The Senate Banking Committee’s bank CEO hearing this week focused in large part on the banking agencies’ Basel capital proposal. Lawmakers and CEOs discussed the potential economic costs of the proposed requirements and the big-picture consequences for the banking system and its customers. Here are some key highlights.

  • Consumer impact: The hearing opened with a misleading statement from Chairman Sherrod Brown (D-OH): “Absolutely nothing in these rules would stop your banks from making loans to working families, to veterans, to homeowners, to small businesses, absolutely nothing.” Ranking Member Tim Scott (R-SC) emphasized the lending implications of the proposal. “If regulations continue to increase the costs of providing a loan, I fear that banks will decrease lending, not only in my home state but across the country,” Scott said. “Decreased lending means increased financial hardship, and increased financial hardship means a reduction in opportunity. That’s my ultimate concern — reducing opportunity for everyday Americans.”
  • ‘Propose now, study later’: Legal and process concerns about the Basel proposal also arose at the hearing. The quantitative impact study should have begun before the Basel proposal was put out for comment, JPMorgan Chase CEO Jamie Dimon said. The resulting shift from regulated to less regulated financial markets should have been studied, he said. “I fear that the ‘propose now, study later’ has become a troublesome new theme in Washington.”
  • Big picture: The Basel proposal’s unintended consequences transcend the banks to which it applies and ripple throughout the economy and financial system, the CEOs emphasized. Banks would have to charge more on loans, including to small businesses, to make a viable return on their cost of capital. Operational risk capital “will increase the cost of simply holding the small business checking account or making a loan,” Dimon said. “It’ll also affect our ability to finance your local community banks, which we often do, your local affordable housing, or the Montana pension plan,” he said in response to Sen. Steve Daines (R-MT). “We provide services to a lot of those smaller banks,” Bank of America CEO Brian Moynihan said. “Those costs of those services will go up to them … it has much more impact than people think.”
  • Calculating the cost: Sens. Scott and Mike Rounds (R-SD) observed that the financial system faces a confluence of overlapping regulatory proposals that have a cumulative impact on the economy.
  • Hedging at risk: Increased capital also affects the cost of hedging risk, such as farmers hedging commodity prices, said Citigroup CEO Jane Fraser. Goldman Sachs CEO David Solomon also noted the effects on airlines hedging jet fuel costs. “If the cost of hedging these risks increases, everything from a can of soda to meat products will be impacted,” JPMorgan’s Dimon said. “Ironically, a proposal meant to mitigate risk will actually increase risk.”
  • Mortgages: Dimon noted that “it’ll particularly diminish mortgages for lower-income people … because the cost of all this is actually much higher on a $150,000 mortgage than on a jumbo $2 million mortgage.”
  • Capital markets: Solomon and Dimon also emphasized Basel’s impact on U.S. capital markets, whose liquidity is vital for businesses and retirees.
  • National security: Lawmakers also discussed the role banks play in preserving U.S. national security. The U.S. banking system is “an extraordinary asset for our country,” Morgan Stanley CEO James Gorman said. “Nowhere, not China, not Europe, not South America, and not the U.K., not the rest of Asia, has a system of remotely having these kinds of strengths.” The vitality of U.S. banking and capital markets is at stake in the Basel proposal – the banking system is a “strategic asset of the U.S.,” Citi’s Fraser said. Dimon said cryptocurrency is a threat to national security: “If I was the government, I’d close it down.” Jane Fraser expressed concern about the risk of money migrating into the nonbank financial sector as a result of the Basel proposal. “We are very concerned that this will undermine some of the strengths and foundations of the unique American financial system.”

Five Key Things

1. Washington Post: The Racial Homeownership Gap is Widening. New Rules Might Make it Worse.

The Basel capital proposal could make mortgages more expensive for homebuyers from minority communities, exacerbating the racial homeownership gap, the Washington Post reported this week. Higher capital requirements for mortgages with low down payments would lead to higher interest rates on those mortgages, the article notes. Housing affordability advocates, bipartisan lawmakers and racial equity groups as well as banks are raising alarm about the proposal, the Post reports.

2. 5 Factors Explaining How the Long-Term Debt Proposal Affects Banks’ Funding Costs

The federal banking agencies proposed a rule to require certain large U.S. banks – those with $100 billion or more in total assets that are not Global Systemically Important Banks – to issue long-term debt. The agencies estimated that banks’ pre-tax funding costs could increase by $1.5 billion. This has real-world implications for large regional banks’ business models and their profitability.

The long-term debt proposal’s impact on banks’ funding costs will be considerably higher than projected by the agencies.

A new BPI post expands the proposal’s cost analysis by incorporating five additional factors that would significantly increase the long-term debt requirement’s impact on banks’ funding costs.

  1. the effects of complying with the requirement at the subsidiary bank level, particularly the effects when a parent company provides funding to its subsidiary bank in the form of long-term debt.
  2. the necessity of replenishing the liquidity coverage ratio at the holding-company level due to the change of intercompany funding arrangements.
  3. the possible rise in risk-weighted assets stemming from the Basel proposal, which would, in turn, raise the LTD requirements.
  4. the need for banks to maintain management buffers to avoid dipping below minimum requirements due to business-as-usual fluctuations in balance-sheet size or composition as well as during market downturns, especially when banks need to refinance debt approaching maturity.
  5. the use of individual bond spreads instead of CDS spreads to avoid an underestimation of bank funding costs as a result of credit and liquidity risks.

Taking all these factors into account, the total bank funding costs for Category II–IV banks are projected to reach $4.9 billionthree times the proposal’s estimated funding costs.

Bottom line: BPI analysis indicates that the LTD proposal significantly underestimates the costs associated with meeting those requirements. There are two key factors behind this underestimation: the requirement that banks maintain the LCR at the holding-company level, which would necessitate a substantial issuance of LTD, sharply increasing funding costs; and the need to use bank specific bond-spreads to measure the cost of the proposal. Furthermore, banks with lower levels of outstanding debt might choose to maintain larger LTD buffers, which would help them better navigate periods of market uncertainty affecting bond spreads.

Recommendation: To mitigate the adverse financial impact of the LTD proposal, particularly on Category IV banks, we recommend that the Federal Reserve tailor the LTD requirements for these specific firms.

3. ‘Real-World Consequences’: BPI’s Baer Joins Panel on Bank Capital

BPI President and CEO Greg Baer participated this week in a Brookings Institution panel on bank capital. Other participants included Barclays bank analyst Jason Goldberg, Stanford professor Anat Admati, Brandeis professor Stephen Cecchetti and moderator David Wessel, a Brookings senior fellow.

  • Stepping back: Baer explained the purpose of risk-based capital requirements and the goal of the Basel framework: making capital requirements more sensitive to the actual risk levels of different bank assets.
  • Credit consequences: Baer gave an example of how capital requirements under the banking agencies’ Basel proposal would reduce the size of households’ credit card lines. Under the proposal, banks would be required to hold capital for the unused portion of credit card lines, even though these lines can be canceled at any time by the bank. That decision has real consequences, Baer said – many people use their credit lines as a backup source of funding to cover emergency expenses. “It’s just an example of how a tiny little credit allocation decision in thousands of pages can have real-world consequences,” Baer said.
  • Business lines: Banks are adjusting their business lines to account for higher capital requirements for certain types of assets, Baer said. “What this proposal is about is choosing at a micro level which types of assets or exposures to advantage over others,” Baer said. When banks say they will “optimize the balance sheets,” they mean they will exit lines of business that require high capital charges, he said, giving the example of the mortgage market.

4. Senators Call for Gruenberg to Resign

A group of senators led by Senate Banking Committee Ranking Member Tim Scott (R-SC) called for FDIC Chairman Martin Gruenberg to resign from office in the wake of alleged widespread sexual misconduct and inappropriate workplace behavior at the agency. “We have significant concerns with your ability to continue leading the FDIC as it seeks to clean up its public image and provide much-needed changes to its workplace culture to return the FDIC to working order,” wrote Scott, Sens. Thom Tillis (R-NC), Kevin Cramer (R-ND), Cynthia Lummis (R-WY) and Steve Daines (R-MT) in a letter to Gruenberg this week. “We call on you to step down as Chairman and Board Member and allow someone with more credibility to address the hostile workplace culture at the FDIC to which you have contributed.”

5. McHenry to Retire From Congress

House Financial Services Committee Chairman Patrick McHenry (R-NC) will retire from Congress at the end of his term, according to an announcement this week. While leading the Committee, McHenry has spearheaded efforts to update financial privacy law and provide a regulatory framework for digital assets. He has also held prudential regulators accountable on important issues such as regulatory tailoring and capital requirements. McHenry’s successor on the Committee is not yet clear.

In Case You Missed It

OCC Issues Guidance on Banks’ Buy-Now-Pay-Later Products

The OCC this week issued guidance urging banks to monitor risks from offering buy-now-pay-later loans. Banks should provide clear disclosures, and ensure borrowers using these products understand their payment obligations and do not take on more debt than they can handle, the OCC said.

  • What is BNPL? Buy-now-pay-later loans enable customers to make a purchase with a loan they pay back in four or fewer installments with no interest charges. They can be offered by banks or nonbanks.
  • The risk landscape: Consumers face particular risks when using BNPL products from fintechs or less regulated nonbank firms. These providers lack the regulatory standards and direct supervision that apply to banks in this market.
  • Regulatory context: The CFPB has also scrutinized BNPL products as a regulatory target.

What’s Causing the Cracks in Money Markets

Strains have emerged in money markets for no apparent reason, but they may signal a future source of fragility in crucial funding channels. On Dec. 1 and 4 the Secured Overnight Financing Rate, a benchmark for repo rates calculated by the New York Fed, rose multiple basis point, although it has since settled back. The next day, someone even borrowed $500 million from the standing repo facility, the Fed’s “this is absolutely not the discount window” lending facility, which is the SRF’s first significant use.  It is unclear what caused the month-end jump in the repo rate because QT has yet to reduce reserve balances – all the decline has been soaked up by the shrinking ON RRP facility. The Fed appears to have shifted its QT plans from “we will stop $350 billion above the level where money market conditions get tight” to the Bank of England’s “we will shrink until borrowing at the SRF picks up” (something BPI recommended over a year ago, see “The Bank of England Just Released Its Plan for Getting Smaller. The Fed Could Learn from it.”) For the plan to work without causing another September 2019-like bout of repo madness, the Fed has a lot of work to do reducing stigma at the SRF and the discount window.  Vice Chair Barr’s speech a week ago (here) was a good start. Recognizing the SRF and discount window as a sources of liquidity in liquidity regulations would help.

The Crypto Ledger

Here’s what’s new in crypto.

  • Where in the world is Binance HQ: New Binance CEO Richard Teng refused to disclose the headquarters location of the crypto firm, echoing the stance of predecessor Changpeng Zhao, who stepped down recently as part of a settlement with U.S. authorities.
  • SEC case: Binance and former chief executive Zhao pleaded guilty to violating U.S. anti-money-laundering requirements, but that U.S. government agreement did not resolve the SEC lawsuit against the company, as noted by the Wall Street Journal.
  • Nice try: In a motion filed this week, the U.S. government disputed bankrupt crypto exchange FTX’s claim that its tax liability was zero. The government said FTX was asking the court to accept tax returns based on fraudulent records at face value.

Bank CEOs on How They Support Their Communities

BPI member bank CEOs who testified at the Senate hearing this week shared how they invest in their communities, from expanded employee benefits to support for rural and low-income customers. Check out highlights from their testimony here.

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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.