BPInsights: February 17, 2024

Federal Reserve Releases Stress Test Scenarios

On Thursday, the Federal Reserve released the scenarios for this year’s stress tests, including four “exploratory analysis” scenarios that won’t affect bank capital requirements. The 2024 stress test scenario is more severe relative to last year’s scenario. It assumes a 6.3 percentage point rise in the U.S. unemployment rate, a 55 percent decline of the stock market, over 400 basis points widening of bond spreads relative to U.S. Treasuries, a 36 percent decline in house prices, and a 40 percent decline in commercial real estate prices. Moreover, large banks with significant trading operations are required to face a Global Market Shock testing their resilience to a very severe market stress event, including the default of their largest counterparty. The GMS also appears to be more severe than last year’s.

Despite the increased severity of the 2024 severely adverse scenario, capital requirements are expected to remain largely unchanged in aggregate. This is because the recent strong performance of banks’ net interest margins supported by the elevated level of interest rates at the onset of the exercise, which helps mitigate the impact of the increased severity in the macro scenario and the GMS.

The exploratory analysis introduces hypothetical elements, such as funding stresses caused by rapid deposit pricing shifts amid rising interest rates and large market shocks. One of the exploratory macro scenarios nearly matches the severity of the 2024 stress test scenario, with rising inflation and interest rates, which is highly unlikely. Furthermore, the Federal Reserve will incorporate funding stress into its projections of banks’ interest expenses, while the largest banks experience additional unrealized losses on securities due to rising rates. Moreover, both exploratory market shocks require banks to simulate defaults of their five largest hedge fund exposures, marking a significant deviation from the existing standard.

Due to the exploratory nature of the additional scenarios and to prevent mixed messages regarding changes in capital requirements, the Fed has announced it will publish only aggregate results for the additional hypothetical risks.

Next week, BPI will release a comprehensive analysis of the stress scenarios.

Five Key Things

1. Supervision Ramps Up in Aftermath of SVB

Federal Reserve Vice Chair for Supervision Michael Barr detailed steps supervisors are taking to increase scrutiny of banks in a speech at the Annual Columbia Law School Banking Conference in New York.  Barr’s remarks focused on the role of supervision and efforts the Federal Reserve has implemented following the March 2023 bank failures including in areas such as commercial real estate lending and liquidity and interest rate risk management. 

  • Goal of supervision: Barr noted that supervision is not intended to prevent all bank failures.  “In a market economy, poorly run firms should go out of business,” Barr stated. “Similarly, the goal of supervision is not to tell a bank that its business model may not work; the market will do that. The goal is to help bank managers and boards focus their attention on weaknesses in their risk measurement and management practices, compliance with law, and the sufficiency of the bank’s capital and liquidity resources given its risk profile.”
  • Failed supervision: Barr acknowledged that his report on SVB found that “Federal Reserve supervisors did not identify issues quickly enough, and when we did identify risks, we were too slow to act with sufficient force to change management behavior.”
  • Increasing scrutiny: “Based on this experience, for large and more complex regional banking organizations, including firms that are growing rapidly, we are assessing such a firm’s condition, strategy, and risk management more frequently, and deepening our supervisory interactions the firm,” Barr commented. “[F]or regional banks that are approaching the $100 billion threshold, we are working to improve coordination between supervisory teams and to share the range of practices at large banking organizations just over the $100 billion threshold. The goal is that the transition to heightened supervision for fast-growing banks is more of a gradual slope and not a cliff. For large banking organizations, we are planning to conduct more horizontal, or cross-firm supervisory examinations, to put our assessment of an individual bank in context and improve the consistency in how we look across banks.
  • Taking action: “Where there are weaknesses in how firms are managing these risks, examiners are requiring firms to take steps to address these weaknesses and encouraging them to bolster their capital position, reduce their liquidity risk, or mitigate their interest rate risk, as appropriate,” he indicated. “[B]ecause of the heightened risk environment and heightened supervisory attention, the Federal Reserve has issued more supervisory findings and downgraded firms’ supervisory ratings at a higher rate in the past year. In addition, we have increased our issuance of enforcement actions.” 
  • Capital and liquidity add-ons:  Barr said the Fed will“continue to evaluate whether we should temporarily require additional capital or liquidity beyond regulatory requirements where the firm has trouble in managing its risks.”
  • Recognizing the weaknesses of supervision: Barr was humble in his assessment noting, “Most people are skilled at pattern detection, but often have trouble contemplating the consequences of events outside of our historical experience. It is important to find ways to break these strictures and think more critically about scenarios that could lead to acute distress at firms.”

Additional Context: BPI has long been focused on supervision and published extensive analysis following the March 2023 turmoil.  BPI has suggested that the supervisory regime is not in need of “tougher” supervision, rather the focus needs to be on substance over process.  Improvements to supervision should appropriately focus supervisory activities, resources, and priorities on risks that are material to the financial integrity of the supervised bank and not immaterial check-the-box exercises. 

2. Treasury Must Act to Stop Dirty Money

BPI submitted a statement for the record on Wednesday to the House Financial Services Committee for its oversight of the Financial Crimes Enforcement Network and the Office of Terrorism and Financial Intelligence. The statement acknowledges the diligence of FinCEN staff but expresses disappointment that examinations for AML compliance have not changed in response to the requirements of the new law.

“Four years since the enactment of the Anti-Money Laundering Act, the AML/CFT examination process remains dysfunctional — focused more on process than substance, more on immaterial matters than material ones,” BPI states. “Many of these key provisions of the Act have not been implemented. Meanwhile, the federal banking agencies have ignored the spirit of the Act, as their examinations continue to produce the problems that the Act was designed to solve.”

Important background:

  • BPI launched an empirical study in 2017 to determine the effectiveness of the United States AML/CFT regime based on data and feedback from banks, law enforcement and other stakeholders.
  • The study resulted in a 2018 report finding that while banks devote thousands of employees and billions of dollars to BSA/AML and sanctions compliance, those efforts are ill-suited to effectively combat illicit finance.
  • As a result of these findings, BPI collaborated with a diverse coalition of stakeholders, including FACT Coalition, law enforcement and national security experts, business associations and non-profit groups to support the passage of the Anti-Money Laundering Act of 2020 – the first major legislative reform to U.S. AML laws since the 1970s.
  • Among its many requirements, the Anti-Money Laundering Act called on the Treasury Department to fundamentally reform the AML/CFT regime to encourage innovation and promote the adoption of technology.
  • Many of the key provisions of the Act have yet to be implemented.

What does BPI recommend?
BPI is asking Congress to urge the Department of Treasury to seek public comment and advance the many reforms mandated in the Anti-Money Laundering Act. BPI specifically makes twelve recommendations that would enhance banks’ ability to combat illicit finance and effectively support law enforcement.

To access the full statement, please click here.

3. BPI’s Bill Nelson Testifies at House Hearing on Discount Window

BPI Chief Economist Bill Nelson testified on Thursday at a House Financial Services Subcommittee on Financial Institutions and Monetary Policy hearing entitled “Lender of Last Resort: Issues with the Fed Discount Window and Emergency Lending.” Nelson’s testimony emphasizes the necessity and benefits of recognizing the Federal Reserve’s discount window as a regular tool for maintaining liquidity in the banking system – not just as an emergency source of funding.

The stigma problem: The discount window serves two purposes – as an unremarkable monetary policy tool and a source of contingency funding for banks. This dual nature of discount window lending has attracted stigma for the last century. Responses to discount window borrowing in the Global Financial Crisis exacerbated the stigma.

“Consequently, one of the Fed’s most important monetary policy and financial stability tools doesn’t work well,” Nelson said in the testimony. “While it is tempting to conclude that stigma is irrelevant because a bank will borrow if it has to, that is incorrect for two reasons.First, in many cases it is not the borrowing bank that is experiencing the liquidity strains but rather a third party, and the Fed is seeking to get banks to intermediate to that third party. That indirect approach will not work if banks won’t borrow.Second, a critical purpose of the discount window is to make banks confident that they will have the funds they need to meet draws on credit lines, deposit withdrawals, or other cash outflows so that they are not forced to pull back from lending or sell assets at fire-sale prices … If using the discount window would get you fired, the fact that you technically have access to the window isn’t going to provide much comfort.”

Another source of stigma: Liquidity requirements, such as the liquidity coverage ratio and internal liquidity stress tests, do not recognize discount window and pre-positioned collateral at the window as sources of bank liquidity. These restrictions contradict the reality that a bank prepared to borrow from the window is more liquid than one that is not. Regulators have told banks to be willing to borrow, but these messages ring hollow when such borrowing capacity is not recognized in liquidity evaluations.

What may come next: Policymakers and analysts have recently contemplated liquidity rule changes that could recognize banks’ readiness to borrow from the discount window. Such recognition could make liquidity assessments more accurate and motivate banks to be prepared to borrow. Banks addressing more short-term contingency funding needs with discount window borrowing, not reserves, could leave room on their balance sheets to lend more to businesses and households instead of amassing government securities or deposits at the Fed.

Why it matters: Recognition of the discount window as a critical tool to address banks’ funding needs both in ordinary times and in stress would promote stability in the banking system and make the Federal Reserve a more effective lender of last resort in crisis.

Recommendations: Policymakers should consider the following steps:

  • Selling banks committed liquidity facilities, or CLFs, which could serve as a backup source of funding in contingencies.
  • Reducing discount window stigma through education and eliminating the requirement for borrowers to be publicly identified.
  • Investigating obstacles to banks pledging collateral at the discount window.
  • Proposing any liquidity rule changes as an advance notice of proposed rulemaking to ensure relevant stakeholder input is taken into account.

4. Financial Trades Call on SEC to Revise Digital Assets Measure

A group of trades including BPI, the American Bankers Association, Financial Services Forum and SIFMA urged the SEC to make changes to its Staff Accounting Bulletin 121 policy that effectively precludes banks from providing custody services for digital assets. SAB 121, which describes how public companies should account for custodial activities related to digital assets, significantly affects banks with custody businesses because it mandates that firms undertaking crypto asset custody services should record a liability and corresponding asset on their balance sheets. This in turn triggers capital requirements for banks that make offering these custody services financially infeasible. Nonbanks are not similarly affected. The trades called on the agency in a letter covered by Bloomberg to exclude certain assets from what counts under the broad digital asset umbrella – for example, tokenized deposits – and to exempt regulated banks from the policy’s requirement to account for custodied digital assets on their balance sheets, while maintaining the requirement that firms disclose crypto activities in their financial statements.

  • Context: SAB 121 faces a Congressional Review Act measure in both chambers of Congress aiming to invalidate it. The bulletin has generated process concerns as well — late last year, the Government Accountability Office determined that SAB 121 is a rule under the Congressional Review Act, and therefore the SEC should have submitted it to Congress for review.

5. Supervisions, Mergers, Regulation: Fed’s Bowman Highlights Key Issues

Federal Reserve Governor Michelle Bowman expressed concerns about core regulatory and supervisory issues in a speech at an American Bankers Association conference this week. Bowman’s remarks and subsequent Q&A focused largely on community banks, but the topics she flagged are also relevant for larger institutions.

  • Tailoring: The principle of tailoring regulation to banks’ size and risk profiles is “particularly important to community banks,” Bowman said, expressing concern about the $2 billion asset threshold for updated CRA regulations. On the Basel proposal, even though it only applies to larger banks, Bowman said “all banks need to be concerned about this, because at the root of this proposal is undoing tailoring.” As an example of a knock-on effect, the proposal could create a red line at $100 billion in assets that makes slightly smaller banks reluctant to merge, she said. “It’s not just the 100 billion and above, it’s that bank that’s at 90 billion right now or it’s at 50 billion and was looking for a partner to merge with,” she said. “So are you going to want to cross that line of 100 billion to become 101 billion? I don’t think that that’s a viable business alternative.” She also gave the example of agriculture-focused banks lending to farmers whose hedging costs will rise under the proposal. “I think it would be helpful for us to have an economic analysis of whatever the final proposal might be, in addition to our quantitative impact study for the institutions themselves,” she said.
  • M&A: Bowman called for “transparency and predictability” in bank regulation, including in the bank merger review process. “While the idiosyncratic features of each bank merger transaction can make it difficult to predict how long the regulatory approval process may take, I remain concerned about delays in average processing times and that subsequent regulatory actions could lead to further delays,” Bowman said.
  • Supervision quality over quantity: Bowman called for supervisors to prioritize core risks, such as liquidity and interest rate risk. “Particularly in the wake of some supervisory gaps in the lead up to the failure of Silicon Valley Bank, one response by bank examiners could be to simply flag as many issues as possible,” she said. “However, we must be very careful not to assess the effectiveness of the supervisory process by the quantity of findings documented in examination reports. Quantity alone does not tell us that we have identified the right issues or taken appropriate steps to ensure these issues are addressed in a timely way.” Unpredictable expectations about supervision can also present a risk for banks, she noted.
  • Interchange: On Regulation II, which involves debit card interchange fees, Bowman said the Federal Reserve Board “really doesn’t want the responsibility for implementing” it. “There is no reason that we need to make changes to this.” Policymakers need to understand the costs of offering debit cards and the significant increase in fraud in recent years, she said. “I think there’s an attack across the Board on fees for service, which I’m not sure I fully comprehend or understand because I think if you ask customers that use products like overdraft, they like that service, and they don’t mind paying a fee for it,” she said. Lowering interchange fees could reduce revenue that supports offering free checking accounts and other valuable products, she said. 
  • Commercial real estate: In the Q&A session, Bowman said banks have options available to address stress in their commercial real estate portfolios. Commercial real estate loans are underwritten differently now than during the Global Financial Crisis, Bowman noted. “[B]anks understand their portfolios better than anyone else,” she said. “And as they’re experiencing … concerns about particular loans in their portfolios, they’re going to address those individually with the borrowers.”

In Case You Missed It

Fed’s Barr Weighs in on SVB, Bank Liquidity

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.

BPI Statement on FinCEN Proposed Investment Adviser Rulemaking

BPI Senior Vice President, Senior Associate General Counsel Gregg Rozansky issued the following statement this week in response to FinCEN’s proposal to amend registered investment advisers’ anti-money laundering and Suspicious Activity Report reporting obligations.

“BPI commends FinCEN for its proposal to require registered investment advisers to implement AML/CFT measures to bolster financial crime enforcement and reduce risk of abuse by money launderers, corrupt officials and other bad actors. Coverage of investment advisers under the Bank Secrecy Act should help to promote trust and transparency in the American financial system, and we strongly support this effort.”

The Crypto Ledger

Here’s the latest in crypto.

  • Stablecoin legislation: Politico reported that Chairman McHenry said he has a deal with Ranking Member Waters on stablecoin legislation, but they are “waiting on the green light from the Biden administration and Senate.” Earlier this week, Federal Reserve Chair Jerome Powell told Democratic members of the House Financial Services Committee that a framework for stablecoins is necessary and he is “glad that we are close” on stablecoin legislation, POLITICO also reported.
  • Crypto crime: The House Financial Services Committee’s digital assets subcommittee held a hearing this week on crypto crime.
  • Digitex founder charged: Adam Todd, the founder of Digitex Futures Exchange, was charged in federal court in Florida with violating the Bank Secrecy Act. Prosecutors accused Todd of failing to maintain an adequate anti-money laundering program and know-your-customer program.

Capital One Report Explores Financial Literacy, Digital Banking

A new report from Capital One explores the relationship between digital financial literacy levels and digital banking preferences and behaviors. The report, based on a survey of 3,000 Americans, notes that 86 percent of Americans are digitally literate and well-equipped to use digital platforms to meet their routine banking needs. However, despite high rates of digital literacy, 40 percent of consumers in the survey lack basic financial knowledge, suggesting that more work needs to be done to help Americans strengthen their financial literacy.

Next Post: BPInsights: April 13, 2024 View Next Post


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.