BPInsights: February 11, 2023

Deep Dive of the DFAST 2023 Scenarios

On February 9, 2023, the Federal Reserve released two scenarios, the baseline and the severely adverse, as well as the Global Market Shock (GMS) add-on component for organizations with large trading operations. The main innovation in this year’s scenarios was the introduction of an additional “exploratory” market shock to evaluate trading losses due to increased inflationary pressures and will only be applied to the U.S. global systemically important banks (GSIBs). The results of the exploratory market shock component will not impact GSIBs’ capital requirements and it is likely intended to test the feasibility of multiple scenarios in future stress tests.

• More severe: The 2023 stress scenario is more challenging than the one from the previous year and features a higher rise in unemployment, a larger decrease in real GDP growth, and a significant drop in house prices. Despite the anticipated rise in loan losses, aggregate pre-provision net revenue may increase mainly due to stronger net interest income, but results are somewhat mixed and depend on whether model coefficients are updated. Additionally, some of the GMS risk factors (such as Treasury rates, S&P 500, and MBS spreads) are less severe compared to the previous year, and the advanced approaches banks are expected to see an increase in the fair value of their available-for-sale securities. Overall, we project that the severely adverse scenario will result in a slightly higher reduction in projected bank capital ratios compared to the results of last year’s stress tests (as shown in Exhibit 5). Moreover, differences in losses between the two market shocks will highlight the banks’ sensitivity to interest rate risk in their trading books.
• What’s next: It is worth noting that updates to the coefficients of pre-provision net revenue models may significantly impact stress test projections, especially given the expansion of banks’ balance sheets during the pandemic. As a result, we will need to wait until March to learn about the updates to the supervisory models from the Federal Reserve.

Read BPI’s full analysis here.

Five Key Things

1. Barr Calls for Boosting Financial Inclusion

Federal Reserve Vice Chair for Supervision Michael Barr stressed the importance of financial inclusion in a speech this week. He highlighted several strategies banks have used to meet the needs of low- to moderate-income and underserved minority communities, such as the Bank On program, support for MDIs and CDFIs and small-dollar loans. He also noted the special purpose credit programs many large banks have launched to provide mortgage assistance to underserved communities.

• Regulatory tools: Barr also previewed the upcoming revamp of the Community Reinvestment Act, which is expected to be finalized this year, as a way to ensure that banks invest in low- to moderate-income communities. He said small business data collected as part of Dodd-Frank Section 1071 requirements would provide insight into the availability and cost of credit for minority-owned small businesses, and urged banks to review AI or algorithmic lending models to prevent discriminatory practices.
• M&A: Barr also mentioned serving communities as a factor in bank merger review. “There is likely important work we can do to improve our assessment of the convenience and needs factor for bank mergers,” Barr said.

2. Convenience and Needs: The Wild-Card Factor in Bank M&A?

In a panel at the OCC’s Symposium on Bank Mergers on Friday, BPI President and CEO Greg Baer provided context and commentary on the “convenience and needs” factor considered in bank merger review. Other panelists were Boston College law professor Patricia McCoy, Columbia law professor Kathryn Judge and Renita Marcellin of Americans for Financial Reform. Here are some key takeaways from the panel.

• Stepping back: The panel centered on the “convenience and needs” factor in bank merger evaluation, which involves how a merged bank would serve the credit needs of its communities. It’s the least developed of all the M&A review factors, Baer noted during the panel.
• Plans: While the banking agencies may not require all banks to submit community benefit agreements when seeking to merge, all the banks whose mergers have been approved in the last five years have done so, he observed. Panelists discussed what kinds of commitments or agreements banks should be required to make, such as plans to preserve certain product offerings or integrate their systems.
• Opacity: The lack of transparency in bank merger review presents problems, Baer said. “It is effectively a secret process, there are no real rules and there are no real deadlines,” he said. The opaque process puts pressure on both the proposed acquirer and the target bank. An unclear process could become more vulnerable to political tensions. Shorter review timelines would also enhance transparency, Baer said. “This would all be a whole lot easier if there were shorter timeframes on all this,” Baer said.
• CRA: Participants also discussed the role of the Community Reinvestment Act in bank merger review. CRA ratings are currently factored into merger reviews, but they could be used to support a more quantitative, objective process. Banks with outstanding CRA ratings should have a presumption of merger approval, Baer suggested.
• Beyond branches: Baer cited BPI research demonstrating that from 1980-2012, the number of bank branches grew significantly even as the number of banks shrank significantly. Branches are not a driver of financial inclusion – key drivers are access to technology, access to smartphones and financial literacy, he said. To delve into financial inclusion, “stop talking about branches and start talking about things like those,” he said.

3. Banks in the Cloud

BPI this week expressed strong support for the Treasury Department’s recommendations to address roadblocks to cloud adoption. The report examines benefits and potential challenges as the financial industry continues to adopt cloud services and recommends opportunities for government, regulators and the private sector to work together to realize the benefits of cloud adoption.

• What BPI is saying: Heather Hogsett, BPI senior vice president, technology and risk strategy, stated: “BPI strongly supports Treasury’s recommendations and comprehensive review of cloud adoption and believes that these collaborative efforts will address key challenges and lead to a safer financial system. Cloud adoption can provide flexibility and efficiency that support innovative products and services while enhancing security and resilience. We look forward to continuing to partner with Treasury to unlock these benefits.”
• Here’s what’s in the report: The recommendations follow consultations with financial institutions of varying sizes, think tanks, insurance companies, financial market utilities, cloud service providers and other critical stakeholders. The report identified the benefits of cloud services and six possible inhibitors that could prevent those benefits from being realized. These challenges aren’t unique to the financial services industry and are shared by regulators and government agencies across nearly every industry. As cloud usage across the public and private sectors continues to expand, a new approach is needed to ensure regulators adopt these recommendations and collaborate to develop consistent and modern approaches to technology regulation and oversight.
• To learn what’s next, click here.

4. Flexibility and Consistency are Key for Regulators’ Approach to Large Banks’ Climate Risk

Policymakers’ guidance for large banks’ climate-related financial risk management should avoid prescriptive requirements and enable banks to maintain flexibility, BPI said in a comment letter responding to the Federal Reserve’s draft principles for large bank climate-related financial risk management. The Fed’s draft principles closely aligned with similar measures from the OCC and FDIC and BPI encouraged the Fed to finalize a single set of principles with the other agencies to promote consistency. The letter also supported the recognition that climate scenario analysis is distinct from traditional stress tests and that banks’ approaches to climate-related financial risk management will differ based on their business models and complexity of operations. The letter also recommended:

• Clarifying that a bank’s board of directors should focus on oversight of material climate-related financial risk.
• Clarifying provisions that could be interpreted as requiring banks to adopt lending limits related to climate risk.
• Clarifying the scope of application with respect to foreign banking organizations. 

5. House Financial Services Panel Eyes China in Financial System

The House Financial Services Committee this week held a hearing highlighting economic competition with China. Chairman Patrick McHenry (R-NC) emphasized the need to maintain trust that the U.S. system will continue to grow capital resources, enhance industrial capabilities and foster new technologies.

• Beyond the balloon: Lawmakers took a broad view of U.S. competition with China and its challenges. Russia’s invasion of Ukraine loomed in the geopolitical backdrop of the discussion. One key theme was the need for the U.S. to compete with Chinese financing in the global economy. Lawmakers also called for ensuring China abides by international rules and raised concerns about its role in global debt markets. Rep. Blaine Luetkemeyer (R-MO) called for increasing scrutiny on U.S.-listed Chinese companies.
• CBDC: Lawmakers also expressed concern about a Chinese CBDC and its potential threat to the U.S. dollar’s reserve currency status. Rep. Stephen Lynch (D-MA) noted that usage of the digital yuan is low so far, but suggested that the cross-border wholesale CBDC pilot in which China is participating warrants more scrutiny.
• Innovation: One question at the heart of the discussion was how to effectively compete with China. “America cannot win this strategic competition with China by trying to be more like China, and be focused on passing more industrial policy measures,” Rep. French Hill (R-AR) said. Others suggested strengthening the Export-Import Bank as an alternative to Chinese financing.

In Case You Missed It

Does Financial Industry Privacy Law Need an Update?

The House Financial Services Committee this week considered privacy standards for financial institutions as the panel unveiled a discussion draft of a financial industry privacy bill. Chairman Patrick McHenry (R-NC), who is spearheading the bill, has marked privacy as a key legislative priority. The draft legislation still faces several steps to move forward, but this week’s Subcommittee on Financial Institutions and Monetary Policy hearing gave lawmakers a chance to make their views on the topic clear.

• Context: The bill would update the Gramm-Leach-Bliley Act, which established comprehensive privacy standards for financial firms. Subcommittee Chairman Andy Barr (R-KY) described it as a modernization of that law to address changes in how consumer data is collected and disclosed. Banks currently face some of the most rigorous privacy requirements of any industry.
• Debate: The draft legislation includes a national standard for financial data privacy that would preempt state rules. Barr said the provision would ensure certainty for firms and consumers in how data is handled, but Ranking Member Maxine Waters (D-CA) noted concerns about preemption of state standards. The hearing also highlighted different views on the right enforcement mechanism for the privacy standards and potential unintended consequences. “Private right of action”—authorizing a private individual, rather than a state, to enforce rights under a statute—would open firms up to frivolous lawsuits, Jim Reuter of the American Bankers Association said at the hearing.

The Crypto Ledger

An ex-Coinbase staffer pleaded guilty this week in what prosecutors call the first crypto insider trading case. The former staffer, Ishan Wahi, faces charges of conspiracy to commit wire fraud over giving confidential information to his brother and an associate that they allegedly used to trade digital tokens. Although Wahi pleaded guilty in the criminal case, he is fighting a civil insider trading lawsuit from the SEC. Here’s what else is new in crypto.

• Kraken’s high stakes: Kraken will pay $30 million in an SEC settlement over allegations that its “staking” service was an illegal sale of securities. The firm will end staking services for U.S. clients.
• Paxos probe: Stablecoin issuer Paxos faces a New York Department of Financial Services investigation, according to CoinDesk. The news comes as the firm denied rumors that the OCC asked it to withdraw its application for a national trust bank charter.
• Celsius burning cash: Bankrupt crypto platform Celsius Network’s bid to extend the deadline to present its Chapter 11 plan faces opposition from a group of creditors who are concerned it might run out of cash. Celsius sought to extend the deadline for exclusively filing a plan to the end of March.
• On the Hill: Two House committee leaders whose oversight purviews include agencies responsible for overseeing crypto are indicating they may cooperate with each other, according to POLITICO. House Financial Services Committee Chairman Patrick McHenry (R-NC) and Agriculture Committee Chairman G.T. Thompson (R-PA) appear to be working together on the crypto issue, according to the article.

PNC Announces Winners of HBCU Entrepreneurship Pitch Competition

PNC recently announced the results of its North Carolina HBCU Pitch Competition, which builds upon the launch last year of a PNC initiative to support students at historically black colleges and universities in the state. The winner of the competition is Jahmir Hamilton from North Carolina Central University, who will receive a $2,500 cash prize for his pitch on empowering people through gaming.