BPInsights: January 27, 2024

4 Key Fixes to the Banking Agencies’ Long-Term Debt Proposal

The banking agencies proposed to require regional banks to issue long-term debt to bolster their resilience. However, the proposal’s costs outweigh its benefits. Four key fixes could improve it.

Here’s the background: The proposal would require these banks have an extra layer of loss-absorbing resources on top of their capital requirements by issuing and maintaining a minimum amount of long-term debt. This extra layer of protection would aim to prevent deposit runs during stress by bolstering depositors’ confidence, and to enhance the FDIC’s options for resolving the bank in an orderly way and reduce losses to the Deposit Insurance Fund if it fails.

Significant costs: The proposed requirement is likely 3x costlier than the agencies have estimated, according to BPI research. These unnecessarily higher costs would divert bank funds from worthwhile economic activities such as financing small and midsize American businesses. One factor in the outsize costs of the proposal is its interaction with the Basel capital proposal.

Four fixes: These four critical changes would help remedy the proposal’s problems.

  1. Recalibrate to a level more appropriate for regional banks. The proposal would generally require a covered bank to hold debt equal to at least 6 percent of its risk-weighted assets. But this amount of long-term debt is unnecessary to improve a regional bank’s resolvability, and is based on requirements designed for the very largest global banks to keep subsidiaries operating during a failure. A lower calibration, such as 2 percent, would be more appropriate.
  2. Eliminate the overly prescriptive internal issuance requirement. The proposal would require a covered bank to issue qualifying long-term debt internally to its holding company, which would, in turn, be required to issue debt to the market. This highly prescriptive “internal issuance” requirement produces higher costs in significant, and likely unintended, ways. The agencies’ regulatory objectives could be accomplished through less prescriptive means that would allow banks more flexibility to manage their internal funding.
  3. Tailor requirements as required by law. The proposal does not differentiate between categories of banks based on their specific characteristics, like their risk profile and complexity, as required by statute. It would also present proportionately higher costs for smaller regional banks – the exact opposite of the intended effect of the tailoring law.
  4. Eliminate the minimum denomination requirement. The proposal would include a novel minimum denomination requirement aimed to prevent ordinary investors from purchasing the debt. But a $400,000 minimum denomination is too high even for institutional investors. The proposal would significantly limit demand for long-term debt while increasing its supply.

Bottom line: There are other issues with the proposal that regulators should address. But these four essential fixes would go a long way to address the proposal’s deficiencies. Enhancing resolvability and resilience are worthwhile objectives. They deserve a reasonably calibrated, operationally feasible, rationally marketable and lawfully tailored method to achieve them.

Five Key Things

1. Bipartisan Lawmakers Warn of Basel Proposal Costs to Farmers, Ranchers, Consumers

A bipartisan, bicameral group of U.S. lawmakers led by Sen. Jerry Moran (R-KS) and Rep. Zach Nunn (R-IA) cautioned in a recent letter against the harmful effects of the Basel proposal on the costs of hedging for farmers, ranchers and, ultimately, consumers. “We have concerns that the GSIB Surcharge Proposal and the Basel III Endgame Proposal will generate disincentives for prudent risk management strategies and drive up the cost of hedging for end-users,” the members of Congress wrote. “Ultimately, consumers who are already facing elevated prices from record levels of inflation will pay the price at the grocery store and the gas station.” The proposal could increase the costs for banks to provide access to derivatives markets for farmers hedging commodity prices and other end users, the lawmakers said.

2. Senators Urge Regulators to Consider Basel Proposal’s Small-Business Consequences

The Basel proposal could impede small businesses’ access to credit or raise their borrowing costs, a group of Democratic senators led by Sen. Gary Peters (D-MI) warned in a letter. “While we recognize the Federal Reserve’s role in overseeing the stability of the U.S. financial system and safeguarding from undue risks, we are concerned about the proposed Basel III Endgame’s impact on small businesses and their ability to access affordable and reliable credit in an already tightened credit environment,” the senators wrote. The pressure could be particularly acute for minority small-business owners, they said. “In a higher interest rate and credit tightening environment, we believe it is essential to weigh the costs and availability of credit impacted by this proposal, particularly for those that need it most.”

3. Clear Recognition of the Discount Window Would Improve Liquidity Rules

In recent remarks, Acting Comptroller Michael Hsu gave a glimpse into the near future of bank liquidity regulation. He recommended explicitly recognizing banks’ ability to borrow from the Fed’s discount window to cover ultra-short-term, acute outflows, such as the runs on Silicon Valley Bank and Signature Bank last spring. In addition to existing liquidity rules, banks should be required to have cash and discount window borrowing capacity that can meet five days of acute stress outflows, he suggested.

Lessons from last year: Liquidity regulation has become a higher policy priority after the spring 2023 bank failures. Hsu drew three lessons from these failures:

  • Uninsured deposits can be withdrawn quickly and en masse.
  • Having liquid assets is necessary but not sufficient for banks to endure liquidity stress—they must also be able to monetize these assets
  • Contagion to healthy banks can occur via “guilt by association,” i.e., shared uncertainty with regards to seemingly similar risk profiles, such as high reliance on uninsured deposits for funding.

Crucial context: Hsu’s remarks seem to reflect a growing consensus among policymakers to recognize discount window borrowing capacity when assessing banks’ liquidity. Clear recognition of discount window borrowing capacity has several benefits:

  • It makes liquidity assessments more accurate – a bank that is prepared to borrow from the discount window, including by having prepositioned collateral, is more liquid than one that is not. 
  • It provides banks with a strong incentive to be prepared to borrow. 
  • It could help reduce the stigma associated with the discount window.
  • It could help the Fed shrink its balance sheet.

Stigma: The discount window has attracted stigma since soon after the Fed’s founding, and the stigma intensified after the Global Financial Crisis. Banks remain concerned that examiners will view discount window usage as a sign of troubled liquidity risk management. Acting Comptroller Hsu’s remark that “[t]he line between being a lender of last resort and providing a bailout can be a fine one, especially in times of stress” raises the specter of continued stigma. The banking agencies should emulate the Bank of England and emphasize that any borrowing – from the discount window or the standing repo facility – is a business decision by the bank and not an indication of crisis.

What comes next: As policymakers consider new liquidity requirements, they should invite public input through an advance notice of proposed rulemaking or a request for information as a first step. Liquidity regulation comes with high benefits and high costs, with no easy tradeoffs.

4. The Line in the CFPB’s Overdraft Proposal

Under the CFPB’s overdraft proposal, an overdraft fee would be considered a loan, and thereby subject to the Truth in Lending Act and Regulation Z, if it is set above a price chosen by the CFPB.  If the fee is set below the price set by the CFPB, then it is not a loan.  Furthermore, if the fee is charged by a bank with less than $10 billion in assets – approximately 4,500 of the nation’s banks — then it is not a loan, regardless of whether it is set above or below the CFPB’s chosen price.  Some observers have suggested that this approach is arbitrary or even politically driven.

5. Paper Links Lower Debit Interchange Cap with Higher Costs for Consumers

A recent paper by former Pew researcher Nick Bourke demonstrates that a proposed reduction of the debit interchange cap would raise costs to consumers by $1-2 billion per year. Bourke infers this from a review of previous, academically rigorous research studies finding that the Durbin Amendment debit interchange cap led to higher consumer costs. He also assesses that the cap’s cost savings benefit touted by retailers is unproven “and is likely unmeasurable.” The paper cites these results to estimate the potential effects of the proposal to lower the debit interchange cap. Key findings of the paper include:

  • Fees for bank accounts increased due to lower interchange revenue from the Durbin Amendment. A drop in interchange revenue arising from a lower cap may preclude banks from offering products like free checking and Bank On accounts that particularly benefit lower-income customers.
  • Claims of merchant and consumer savings under the Durbin Amendment are contested or not measurable. Retailers have emphasized their ability to pass savings on to consumers as a result of the Durbin cap, but the evidence is unclear that they actually did so. “Though debit processing costs went down for merchants on average, benefits are unevenly distributed due to variances in merchant business models and agreements with their acquiring banks,” the study says. “Net merchant savings are not certain, in part because other processing costs increased as consumers shifted away from debit card usage. If merchants passed savings through to consumers, as theory suggests, economists concluded it is ‘virtually impossible’ to prove or measure.”
  • If the current proposal to reduce the debit interchange fee cap is finalized, the research suggests that consumers will pay an extra $1.3 billion to $2 billion annually in higher bank account fees.
  • Bottom line:Based on robust evidence, there are likely to be adverse consequences for consumers from the Fed’s proposal to reduce the debit interchange cap.

In Case You Missed It

BPI, Trades File Amici Brief in US Supreme Court Case on National Bank Preemption

BPI and other bank trades this week filed an amici brief in support of Bank of America in a Supreme Court case, Cantero v. Bank of America, the outcome of which is expected to set important precedent relating to the ability of national banks to continue to operate under a uniform set of federal banking rules anywhere in the US. Preemption is the legal principle that federal requirements supersede conflicting state laws – in this case, particularly for national banks supervised by the OCC. The question at the heart of the Cantero case is whether a New York state law requiring lenders to pay interest on borrower funds held in escrow is federally preempted for national banks. The U.S. Court of Appeals for the Second Circuit ruled in favor of federal preemption.  The outcome of the case would affect the costs of mortgage escrow accounts maintained by banks, but more broadly could reverberate beyond mortgage lending into the entire banking sector.

  • The argument: Dismantling national bank preemption would subject national banks to a patchwork of 50 state laws, BPI and the other trades contended in the brief. The groups disputed the U.S. Solicitor General’s notion of national bank preemption being decided on a case-by-case and even bank-by-bank basis, noting that it would “lead to the re-litigation of prior preemption determination based on the individual circumstances of particular national banks with inconsistent determinations—an outcome that would most benefit plaintiffs’ lawyers and create widespread uncertainty in the national banking system.” On mortgages in particular, the trades noted that under long-settled law the ability to establish and set terms for mortgage escrow accounts is part of a national bank’s powers.
  • Worth noting: A group of former OCC officials filed a brief in support of Bank of America as well.

Fed Delays Comment Deadline for Debit Interchange Proposal

The Federal Reserve announced on Monday that it has extended the comment deadline on its Regulation II (debit interchange) proposal from Feb. 12, 2024 to May 12, 2024. The Fed is considering lowering the cap on debit interchange fees.

Lessons for Preventing Bank Runs from 1920s Virginia

The Richmond Fed’s actions to stabilize Virginia banks in a 1920-1921 recession provide a useful example for a key liquidity challenge today, according to a study by BPI’s Haelim Anderson, Carnegie Mellon University’s Selman Erol and the University of Pennsylvania’s Guillermo L. Ordoñez. In the 1920s, the Richmond Fed “passed through” its stability to banks in its home state grappling with depressed cotton prices and panicked depositors. Its effective lender of last resort function prevented bank runs from metastasizing into a banking crisis. This episode – which predates federal deposit insurance — gives insight into potential improvements in lender of last resort function in the wake of the spring 2023 banking turmoil, which was exacerbated by the banks’ failure to access discount window lending. The study presents evidence that effective LOLR support enhances banks’ ability to manage run risk.

The Crypto Ledger

Here’s what’s new in crypto.

  • Terra bankruptcy: Terraform Labs, the company behind the TerraUSD stablecoin that collapsed in the early stages of the crypto winter, has filed for bankruptcy in the U.S.
  • Crypto fraud: In a particularly unusual defense, a Colorado pastor accused of cryptocurrency fraud claimed that God told him to get into crypto.
  • Digital sterling: U.K. authorities will not decide until next year at the earliest on whether to issue a central bank digital currency, according to Reuters. The Bank of Engand and British finance ministry will continue preparatory work after a public consultation on the potential for a digital pound. Among the outstanding questions on the project: privacy concerns.

CFPB Announces Proposal on NSF Fees

The CFPB this week announced a new proposal to ban nonsufficient funds fees on “transactions that are declined instantaneously or near-instantaneously—that is, those declined with no significant perceptible delay after the consumer initiates the transaction.” The Bureau went on to say that “[t]his prohibition would cover transactions involving the use of debit cards, ATMs, or certain person-to-person apps.” A CFPB report finds that the vast majority of banks do not charge these fees.

Synchrony and Ally Financial Reach Agreement on Sale of Ally’s Point-of-Sale Financing Business

Synchrony and Ally Financial this week announced an agreement for Synchrony to purchase Ally’s point-of-sale financing business, including $2.2 billion of loan receivables. The acquisition “includes relationships with nearly 2,500 merchant locations and supports more than 450,000 active borrowers in home improvement services and healthcare.”

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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.