BPInsights: February 3, 2024

On Capitol Hill, Basel Raises Bipartisan Concerns

The Basel capital proposal would raise the cost of borrowing for consumers and businesses and disrupt capital market liquidity, BPI CEO Greg Baer said on Capitol Hill this week. Baer, Davis Polk attorney Randall Guynn, Americans for Tax Reform’s Bryan Bashur and University of Michigan Assistant Professor Jeremy Kress testified on Wednesday before the House Financial Services Committee’s Subcommittee on Financial Institutions and Monetary Policy at a hearing on bank regulatory proposals.

“If adopted, the capital rule proposed by the federal banking agencies would have a profound effect on the availability and cost of credit for nearly every American business and consumer, as well as on the resiliency of U.S. capital markets. Given the stakes involved, the proposal is remarkable for its lack of analytical rigor, and its aversion to the use of relevant data,” Baer said in his testimony. Here are key highlights from the hearing.

  • Operational risk: Lawmakers and witnesses emphasized the operational risk charge as a core problem of the proposal. Operational risk would hit everything from mortgages to the fee-income business lines on which U.S. banks in particular rely.
  • Mortgages, small businesses, environment: Several Democratic lawmakers including Reps. Brad Sherman (D-CA), Gregory Meeks (D-NY) and David Scott (D-GA) reiterated concerns about the proposal’s effects on homebuyers, particularly minority or first-time homebuyers. Sherman noted that the proposal hurts “first-time homebuyers, small businesses and the environment.”
  • Rural communities: The proposal would harm rural communities, farmers and ranchers, Rep. Monica de la Cruz (R-TX) said at the hearing. “The repercussion of it could be crippling local economies like mine that are rural and that are largely Hispanic,” she said.
  • Confluence of requirements: Lawmakers including Rep. William Timmons (R-SC) flagged the combination of multiple regulatory proposals, such as the banking agencies’ proposed long-term debt requirement. Separately, Baer emphasized the overlap between the Fed’s stress test and the Basel proposal, a unique factor in the U.S. as opposed to other jurisdictions. He also observed that “one of the concerns here is that even within the Basel proposal, the overlay between operational risk and credit risk has not been considered,” Baer said. “Punitive charges” on securitization would also hurt banks’ ability to make auto and credit card loans to low-income people.
  • Rulemaking process: The agencies had voluminous data at their disposal – for example, on banks’ losses related to certain types of risk – and failed to use it in formulating their proposal, Baer said. Rep. Andy Barr (R-KY) called on the banking agencies to re-propose the rule. “Rules without analysis lead to bad policy outcomes, and invite mistakes that will later be called unintended consequences,” Rep. Barr said.

The Basel proposal had just two wholehearted defenders at the hearing, including Assistant Professor Jeremy Kress, in contrast with significant concern from both Democratic and Republican lawmakers.

Five Key Things

1. The Big Picture of Basel Proposal Comments: ‘Opposition and Significant Concerns’

A review of more than 350 comments on the Basel capital proposal paints a picture of “opposition and significant concerns,” according to law firm Latham & Watkins, which compiled the comment report. Here’s a look at its key findings.

  • More than 97% of commenters in the analysis opposed the proposal or raised significant concerns. About 86% of negative comments came from outside the banking sector. Opposition or major criticism of the proposal came from civil rights groups, farmers, pension funds, small businesses, housing groups and bipartisan members of Congress.
  • Commenters representing a broad swath of the economy – manufacturers, a varied range of businesses, pension funds – called for the rule to be re-proposed or withdrawn entirely.
  • A significant majority of elected officials, both Democratic and Republican, joined comment letters opposing the proposal or expressing major concerns with it.
  • Why they oppose it: Core themes in commenters’ arguments against the proposal included: overlap with the stress tests, violations of administrative law, meaningful flaws in the operational risk charge, an already well-capitalized banking sector, and harm to the economy, homeownership, small businesses, minority communities, the environment and capital markets.

2. What’s Ahead for National Bank M&A from OCC Remarks, Proposals

Earlier this week, the OCC proposed certain changes to its procedures for processing bank merger applications and also proposed a policy statement on factors used by the OCC to evaluate bank M&A applications.  Acting Comptroller Hsu previewed the proposals during a speech at the University of Michigan.  The proposals, described largely as an effort to increase transparency for potential bank merger applicants where the resultant bank would be regulated by the OCC, will be open for public comment.

  • Big picture views: Hsu laid out in his remarks a vision of the banking system, saying policymakers should develop a macro view of what the banking system should look like. “To the extent that such concentration of the largest banks … is a concern, the right policy question to ask is: How can that concentration be addressed while also supporting and balancing the diversity, dynamism, and size of the U.S. economy?” Hsu said.
  • Proposed changes to the OCC’s procedures: The OCC proposed to eliminate a rarely used procedure that allows certain internal reorganizations to be deemed approved 15 days after the close of the comment period.  The proposal would also eliminate the streamlined Bank Merger Act application form for certain smaller transactions such as internal reorganizations.  Factors that could lead to longer public comment periods and processing times were also addressed.
  • Proposed OCC policy statement on bank M&A: The proposed policy statement outlines considerations that would make the OCC either less likely and more likely to approve a merger (e.g., resultant bank has less than $50 billion in assets would be a more likely factor).   In the former category, various factors — outside of antitrust considerations — that could scuttle a deal approval include:  size of the acquiror (being a Global Systemically Important Bank), a bank with a “3” examination rating, or an open investigation on AML or fair lending referral to the DOJ.
  • Other insights from Hsu: In a Q&A after his remarks, Hsu also suggested the FDIC’s “least cost” test for bank resolution may need changes. That measure requires the FDIC to pursue the resolution option for a failed bank that imposes the lowest cost on the Deposit Insurance Fund. The comment came in response to a question about JPMorgan’s acquisition of First Republic after the latter bank’s failure last year.   Hsu also noted that work on competition guidance for bank m&a transactions is ongoing.
  • Bottom line: The actions do not resolve the issue of deals languishing in regulatory limbo, potentially for years. This is a critical problem for bank M&A, as banks in approval limbo lose the confidence of employees and investors. Despite the stated goal of increasing transparency, the proposal could actually intensify uncertainty for deal timelines. The ultimate implications of this new M&A proposal and policy statement remain to be seen, but it appears the path for M&A growth for many banks may be narrower, not clearer.

3. 7 Recommendations to Better Combat Financial Scams and Fraud

BPI submitted a statement for the record this week at a U.S. Senate Banking Subcommittee hearing on “Examining Scams and Fraud in the Banking System and Their Impact on Consumers.” The statement highlights banks’ efforts to protect customers against scams and fraud and makes seven recommendations the government can take to help the industry further mitigate these risks.

“The issue of combating scams and fraud is a nationwide challenge, one in which banks invest substantial resources to protect their customers and their customers’ money. Such a far-reaching challenge demands comprehensive, multi-dimensional solutions,” the statement remarked. “Collaboration across the private and public sectors is crucial to help protect the American consumer from criminals who seek to defraud them.”

$9.3 billion is spent annually on fraud detection and prevention tools, according to Juniper Research.

Banks employ many safeguards to help protect customers including consumer education campaigns, access and encryption controls, account monitoring and real-time alerts. However, better coordination and collaboration with government would strengthen banks’ efforts to prevent and detect scams and fraud, particularly when these efforts are perpetuated by foreign nationals or rogue nation-states. In its statement, BPI makes the following seven recommendations:

  1. Appoint a federal director to take ownership on fraud and appoint a single federal agency as the national champion to lead and coordinate the fight against fraud.
  2. Equip the U.S. government to play a leading role in helping educate consumers on how to protect themselves.
  3. Promote and enable data and intelligence sharing between institutions and ensure laws are in place that support sharing of information.
  4. Ensure all sectors are properly held accountable to help mitigate fraud and scams.
  5. Increase law enforcement resources needed to prosecute fraudsters and ensure the sentences for fraud are effective deterrents.
  6. Modernize payments by promoting the use of secure electronic payment methods and reducing the use of paper checks.
  7. Eliminate screen scraping as a way for third parties to access banking information.

4. Powell, Hsu Express Concern to Rep. Barr on SEC Custody Rule

Two top bank regulators shared concerns with Rep. Andy Barr (R-KY) and other members of the House Financial Services Committee on the SEC’s proposed custody rule, according to POLITICO. Federal Reserve Chair Jerome Powell and Acting Comptroller Michael Hsu observed in letter responses to Rep. Barr that the proposal represents a notable departure from bank custody practices. “The proposed rule would, if adopted, require a significant change in custody practices at depository institutions,” Powell wrote. The proposal’s “liability and indemnification requirements would be another departure from current practice,” Hsu wrote. The officials said they are in discussions with the SEC on the final rule.

  • Overreaching rule: The SEC’s custody proposal would increase costs and reduce returns for retirees and other investors by dramatically altering its rules for how registered investment advisors handle clients’ assets. Among the proposed changes is a disruptive overhaul to how bank custodians handle customer cash.

5. The Capital ‘Choice’ Misconception

Acting Comptroller Michael Hsu’s recent comments to the Financial Times on capital – linking the Basel proposal to banks’ dividend and buyback decisions – politicize the policy debate and betray a misunderstanding of bank capital distributions, Cato Institute’s Norbert Michel wrote in a recent op-ed. Hsu said in a recent FT interview that “The banking industry has said the new rules are going to hurt all kinds of folks in the real economy. I have encouraged them—provide analysis on what your share buybacks and dividend policies are going to be under these different scenarios. Because there’s a choice to be made with capital.” That comment, according to Michel, suggests a misunderstanding of banks’ capital distribution decisions: Buybacks don’t hurt the real economy, and “while the cost of banks’ capital ultimately affects their profit and, therefore, how much they have left to distribute to their shareholders, switching their payout method (or reducing their payout) does not lower their cost of capital.” Companies decide to return equity to shareholders in the absence of other projects worthy of investment, not as an alternative use of regulatory capital.

In Case You Missed It

Banks Have the Risk Management Expertise to Handle Tech Innovation. What They Need is Regulatory Clarity.

Banks must strike a balance between sound risk management and innovating to meet customer demand. A relevant example of this balancing act is banks’ innovation in distributed ledger technology. Banks using this technology are placing risk management at the forefront of their strategy. But while banks are already equipped with the risk management expertise to balance the risks and benefits of such technological innovation, they lack clear guidance from the prudential regulators. A new BPI blog post illustrates a case study in banks’ use of innovative technology and the need for regulatory clarity.

What it is: Distributed ledger technology, or blockchain technology, is associated with cryptocurrency, but it is simply a new way to record and maintain information without relying on a centralized system or party. It functions like a shared Excel spreadsheet. Network participants all have access to the same shared ledger that reflects the current state of the world and agree on transactions in real time, which can reduce costs and the time associated with reconciling information between or among multiple entities’ individual ledgers. Smart contracts, which are contracts with the terms of the agreement directly written into code, can self-execute on DLT. The technology thereby facilitates the simultaneous execution of the legs of a transaction among participants, reducing the time to complete transactions and counterparty risks from lags between instructions and settlement. Finally, DLT employs advanced cryptography to ensure secure, tamper-evident, and immutable transaction recording, enhancing trust and security.

How banks use it safely: Banks have demonstrated that they can effectively manage the risks presented by private-permissioned DLT. Working closely with the banking agencies, they have begun to incorporate DLT into traditional banking products and services to make those products and services safer and more efficient. Examples include:

  • Using DLT-based deposit accounts to clear and settle repo trades and conduct inter-affiliate transfers.
  • Transferring programmable tokenized deposits to provide instant payments to service providers via smart contracts in the trade finance ecosystem
  • Using DLT for secure and efficient recordkeeping.

The challenge: Banks lack clear direction from their regulators on how to proceed when employing this technology. Banks have been consulting with the regulators and experimenting safely with permissioned DLT for several years, but the current expectation is that they engage in extensive and time-consuming consultation with the regulators before deploying permissioned DLT and, in some cases, obtain an explicit regulatory signoff to proceed with the use of DLT. At best, this process can take many months to complete. At worst, banks may never receive a clear answer. While the agencies have made public statements supporting innovation, the current application of guidance creates barriers to bringing solutions to the market promptly and efficiently. The agencies have issued guidance on top of guidance, promising clarity and forward motion but ultimately falling short.

Bottom line: The potential harm of banks using permissioned DLT within the regulatory framework is low, and the benefits could be significant if regulators enable a path forward with clear actions. The adoption of blockchain technology should not be treated differently or more punitively than the adoption of any other technology, and the agencies should help banks move innovation forward safely, efficiently, and effectively.

Lawmakers Introduce Bill to Invalidate SEC Digital Assets Custody Measure

Reps. Mike Flood (R-NE) and Wiley Nickel (D-NC) on Thursday introduced a resolution under the Congressional Review Act to repeal the SEC’s Staff Accounting Bulletin 121, which prevents banks from providing custodial services to digital assets investors by requiring them to keep those assets on their balance sheet. Sen. Cynthia Lummis (R-WY) introduced a companion measure in the Senate.

  • BPI view: “The Bank Policy Institute thanks Senator Lummis and Representatives Flood and Nickel for their work in opposing the Securities and Exchange Commission’s Staff Accounting Bulletin 121. BPI’s initial concerns that this would preclude highly regulated U.S. banking organizations from providing a custodial solution for digital assets at scale have been confirmed. The result is that digital asset custodial services are currently offered by a multitude of non-banking organizations, keeping the activity outside the prudential perimeter and outside of banks with comprehensive and robust risk management practices, thus increasing risks for customers.”

The Crypto Ledger

Here’s what’s new in crypto.  

  • Terrorism lawsuit: Families of U.S. hostages and other Hamas victims in Israel filed a lawsuit in U.S. District Court in New York against crypto exchange Binance over allegedly facilitating financing for Hamas and other terrorist groups. The complaint was brought “by and on behalf of United States citizens who were murdered, maimed, taken hostage, or otherwise injured in unspeakable acts of terror perpetrated by Hamas and other terrorist groups in the State of Israel on October 7, 2023.” The plaintiffs also sued Iran and Syria.
  • FTX death knell: Bankrupt crypto firm FTX has abandoned plans to relaunch its exchange and instead plans to pay all its customers back in full through a liquidation process, according to Reuters.
  • New crypto fraud charges: The Department of Justice and SEC announced parallel charges against alleged crypto Ponzi scheme HyperFund and its cofounder and two key promoters.
  • Binance UK headwinds: Binance has faced regulatory obstacles trying to re-enter the UK market after British regulators clamped down on crypto marketing. Binance has sought to partner with other organizations to be able to market its products in the UK, but has been turned down by several potential partners.

BofA’s Moynihan, Citi’s Dugan on Global Risks, Economic Outlook, Regulation 

Bank of America CEO Brian Moynihan and Citigroup Chairman John Dugan weighed in on various economic and regulatory topics in recent Q&As with POLITICO. On the Basel proposal, Moynihan said “[The proposed rule] could be withdrawn. It could be re-proposed. It could be changed dramatically. There’s a thousand things that could happen.” Check out Moynihan’s Q&A here. Dugan gave perspective on Russia, China, the economic outlook and AI.

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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.