The Underestimated Risk in Bank Regulators’ Innovation Approach: Banks Falling Behind
While the banking agencies may be overestimating the risk of banks adopting innovative solutions like distributed ledger technology, it’s imperative they do not underestimate another risk: banks failing to adopt new technologies. A new BPI blog post explains how.
The series: A previous blog post in this series laid out the time-consuming, opaque process banks must undergo with their regulators to implement new technologies like permissioned DLT. That post detailed the benefits of banks using such technology, such as improved efficiency and security.
The impending risk: Banks’ failure to adopt new technologies may raise serious risks for banks, consumers, and the financial system if regulators do not clear the path for bank innovation. For example, failure to act soon could expose customers to threats posed by quantum computing that could decrypt sensitive financial information.
A better way forward: The blog post recommends a better way forward to help achieve the regulators’ stated goal of fostering safe yet rapid innovation by banks. The regulators should:
- rebalance their risk assessment of bank adoption of novel technology;
- streamline the process for lower-risk activities where banks have already demonstrated they can operate safely and soundly;
- enhance agency expertise in novel technology; and
- engage in public-private partnerships with banks to encourage safe innovation.
Five Key Things
1. Capital, Stablecoins, Commercial Real Estate: Yellen on Capitol Hill
Treasury Secretary Janet Yellen testified before the House Financial Services Committee and Senate Banking Committee this week at regular hearings on the Financial Stability Oversight Council, which she leads. Here are some key highlights from her testimony.
- Capital: Yellen received several questions from lawmakers on the Basel capital proposal. She deferred to the banking agencies on the proposal, without weighing in on its substance: “The proposals are out for comment and it’s really up to the banking regulators to decide on the appropriate specifics,” Yellen said at the House hearing. When asked about Silicon Valley Bank’s failure and “adequate capital,” Yellen mentioned some actual factors at play in the bank’s demise, such as “their management of interest rate risk, which had produced mark-to-market losses on long-duration assets that they held … coupled with very heavy reliance on uninsured deposits” concentrated among a group of tech firms. Rep. Frank Lucas (R-OK) raised concerns about the Basel proposal’s effect on Treasury market liquidity; the proposal could discourage banks from market-making activities that support liquidity. Rep. David Scott (D-GA) said he is “deeply concerned” that the Basel proposal will diminish credit availability and weaken U.S. economic conditions.
- Commercial real estate: Yellen said the FSOC has discussed commercial real estate lending among smaller banks as an area of focus. “I hope and believe it will not end up being a systemic risk to the banking system,” Yellen told the Senate Banking Committee Thursday. “Exposure of the largest banks is quite low. But there may be smaller banks that are stressed by these developments.”
- Stablecoins: Yellen called for Congress to pass legislation on stablecoin regulation and the “spot market for crypto assets that are not securities.”
- Nonbank mortgage risks: At the Senate hearing, Yellen said policymakers are monitoring risks among nonbank mortgage providers. “FSOC is very focused on that because nonbank mortgage companies lack access to deposits, which banks have,” Yellen said. That makes their funding less stable, particularly in stressed conditions. This source of risk is important as the Basel proposal’s higher capital requirements for mortgages could reinforce nonbanks’ dominance in the mortgage market.
2. New Note Questions the Conventional Regulatory Narrative of a Social Media Run on SVB et al. in March 2023
The run on SVB played out on Twitter, but didn’t originate there. A recent Financial Times Alphaville piece by Yale’s Steven Kelly disputes the concept of a social media-fueled bank run, the way that several policymakers have characterized last year’s fatal run on Silicon Valley Bank. The run emerged via more sophisticated channels such as private group chats among a network of related venture capitalists, Kelly suggests. The article cites a list of SVB’s largest depositors, which are major companies like stablecoin firm Circle, TV provider Roku and venture capital firm Sequoia, not retail depositors. An accurate picture of present-day bank runs is essential for regulators as they prepare to propose new liquidity requirements and direct bank examiners’ scrutiny in liquidity crunches. Here are some key quotes:
- “[T]the closest thing we have to a first-hand recounting of events from those who actually ran on SVB … quite explicitly says the genesis of the run on SVB was private communications among a networked group of sophisticated investors, not Twitter.”
- “Twitter and digital apps are retail phenomena. Corporate treasury departments already read the financial press, and they aren’t pulling hundreds of millions via digital app (which is often not even possible, nor is that likely even materially faster than calling their banker).”
- “Before we assign the bank supervisor army to spend their time doomscrolling, and before we throw out the post-GFC rulebook and make banks be able to fully liquidate in 30 minutes or less, let’s get the first-order macro and balance sheet analyses right. Just because we can watch modern bank crises on Twitter, doesn’t mean that’s where they happen.”
3. To Promote Bank Safety and Effective Governance, Bank Directors Must Be Able to Do Their Jobs
Bank boards serve a critical oversight function. Legal and regulatory frameworks should enable banks to recruit the most qualified directors and bank boards to devote their time and efforts to the highest-level organizational priorities. The FDIC issued proposed corporate and risk governance guidelines as part of its response to the spring 2023 bank failures. Unfortunately, the FDIC’s proposed guidelines neither explain how its proposed vastly expanded board duties would promote bank safety and soundness nor take into account their conflicts with state law. This proposal would have a chilling effect on the ability of covered banks to recruit qualified directors. Rather than impose a prescriptive, one-size-fits-all approach to governance, the FDIC should withdraw and reissue the proposal only after correcting fundamental process and substance deficiencies, BPI and American Association of Bank Directors said in a comment letter submitted this week.
“We recognize the importance of corporate and risk governance structures and how they further safety and soundness at covered institutions. The proposal, however, would create obstacles to the prudential management and performance of covered institutions . . . the proposal also lacks any cost/benefit analysis, particularly with respect to its impact on the ability of covered institutions to attract and retain qualified directors.” – BPI and AABD
The problem: The proposal departs from existing law and corporate governance principles in several ways and is significantly flawed. Among other issues, it:
- Creates director recruiting challenges for covered banks by inappropriately expanding responsibilities, increasing personal liability for directors and introducing a novel director qualification requirement that at least a majority of bank directors be independent not only from bank management, but also from the board of the parent company (contrary to well-established principles of “independence” and fundamentally altering the current structure of many impacted boards).
- Distracts both boards and management from performing their core functions for the bank by inappropriately conflating their responsibilities, including by implying that bank boards may be expected to approval all a bank’s policies (contrary to existing regulatory guidance and practice), and requiring boards to confirm compliance with all laws and regulations (contrary to existing regulatory guidance and practices, and effectively impossible in practice).
- Overrides state corporate law creating confusion, presenting major questions of public policy and contradicting obligations for boards by requiring covered bank directors to consider the interests of a broad array of “stakeholders”, undermining the ability of boards to meet their fiduciary duties to their banks and shareholders under state law.
- Strays far afield from corporate and risk governance guidance issued by the OCC and Federal Reserve — which is better tailored to the individual business model, size, complexity, and risk profile of banks subject to the guidance — imposing significantly different board and risk management requirements on state non-member banks compared to similarly sized national banks and state member banks.
- Takes the wrong lessons away from the spring 2023 bank failures. The deficiencies in those cases were not the processes and formats prescribed by the FDIC’s proposal, but insufficient focus on core financial conditions and certain key risks that threatened the failed banks’ financial integrity, combined with too much focus on non-financial risk management and associated processes.
Why it matters: The FDIC has not demonstrated a justification to override long-standing, foundational principles of board responsibilities and state law as described in BPI’s Guiding Principles on Corporate Governance. Indeed, the absence of any cost-benefit analysis is particularly glaring in view of the extensive studies conducted by the FDIC and other government agencies on recent bank failures. The proposal fails to draw any linkage, and we believe there is none.
Recommendation: The FDIC should withdraw the proposal. Any reissuance of the proposal should only occur after correcting its fundamental process and substance deficiencies.
4. OCC’s In-House Court System Faces Scrutiny
Arguments from a former bank compliance chief against an OCC enforcement case demonstrate ongoing scrutiny of the agency’s in-house courts. Laura Akahoshi, former chief compliance officer of Rabobank, urged the U.S. Court of Appeals for the Ninth Circuit to set aside the entire proceeding against her under the Administrative Procedure Act, even after the OCC dropped the matter last year. The OCC had accused Akahoshi of intentionally withholding a report that had been requested by agency examiners during an examination that took place over 10 years ago. Akahoshi argued that the enforcement action was “unconstitutional, unlawful, untimely and meritless” from the start and has harmed her reputation. Acting Comptroller Hsu dismissed the action last year noting procedural flaws in the ALJ’s hearing on the matter. The Acting Comptroller nonetheless noted that “Bank personnel are required to give any OCC examiner prompt and complete access to [books, records and documents] during examinations of any length, scope, or type. Nothing in this decision alters, lessens, or obviates these supervisory expectations.”
- The big picture: These are the latest claims calling into question the legality and fairness of the banking agencies’ administrative law judges’ process and framework. The SEC’s in-house courts are at the heart of a pending Supreme Court case, SEC v. Jarkesy. Attorneys representing a former bank executive filed an amicus brief in that case highlighting significant alleged abuses in an adjudication before an OCC ALJ .
5. Overdependence on Short-term Wholesale Funding: A Historical Perspective
After the Global Financial Crisis, regulators introduced the net stable funding ratio to discourage banks from relying on wholesale funding from interbank markets and to ensure they maintain a long-term stable funding structure. That rationale echoes Virginia state bank regulators’ concerns in the 1920s about banks depending on borrowing from other banks. A new BPI analysis assesses the financial stability implications of bank funding structure. The analysis uses data from 1922 to compare balance sheet characteristics and deposit rates of habitual borrowers and non-habitual borrowers. The analysis shows that habitual borrowers relied more on borrowed money than non-habitual borrowers, while holding fewer liquid assets and more loans; these frequent borrowers also displayed lower profitability. There was no apparent difference between the two groups in deposit composition, but habitual borrowers may have offered higher rates on time-deposit accounts than non-habitual borrowers. The study highlights the importance and challenges of ensuring a stable funding structure for all banks.
In Case You Missed It
The Crypto Ledger
Here’s the latest in crypto.
- Stablecoin bill: House Financial Services Committee Ranking Member Maxine Waters (D-CA) said this week that lawmakers are “very, very close” to agreeing on stablecoin legislation. Waters has been negotiating with Committee Chairman Patrick McHenry (R-NC) on a compromise for several months, according to POLITICO, but stablecoin legislation has been the subject of debate for more than a year. At a recent House hearing on FSOC, Treasury Secretary Janet Yellen called for Congress to pass legislation on stablecoin regulation.
- New target audience: Some financial firms, such as VanEck, Bitwise, Wisdom Tree and Grayscale, are marketing bitcoin ETFs to investors in the Baby Boomer generation, according to the Wall Street Journal. The marketing push comes after a recent SEC approval of the products.
- Fintech executive convicted: A former executive at fintech company Hydrogen Technology Corp. was convicted by a federal jury this week of conspiring to manipulate the market for Hydrogen’s digital assets.
PNC Recognizes Winners of 2024 PNC North Carolina HBCU Pitch Competition
PNC this week announced the winners of its second PNC North Carolina HBCU Pitch Competition, which recognizes student entrepreneurs from historically Black colleges and universities. Tyshawn Adams from Fayetteville State University placed first in the competition and will receive a $3,000 cash prize for his winning pitch.