BPInsights: July 1, 2023

Key Points on the 2023 Stress Test Results

BPI Executive Vice President and Head of Research Francisco Covas issued the following response to the Federal Reserve’s release of the 2023 stress test results:

The 2023 Federal Reserve stress test results released this week demonstrate that large banks in the U.S. are highly resilient to a severe stress scenario. Overall, the maximum decline in the aggregate common equity tier 1 capital ratio – a key metric in the test – decreased compared to last year’s tests. This decrease will likely translate into modestly lower capital requirements for the banks subject to the test.

There appears to be a significant misunderstanding among some media outlets and policymakers regarding the nature and purpose of the stress test results released this week. The annual stress test is no longer a test that banks “pass” or “fail”; it no longer functions as a traditional supervisory exercise like the Supervisory Capital Assessment Program during the global financial crisis. Instead, since 2020, the hypothetical losses calculated for each bank are transformed into a capital charge that is added to each bank’s minimum capital requirements. Capital regulations limit the ability of banks that do not hold the required capital to distribute earnings to shareholders.

• Therefore, the stress test is now a capital regulation, albeit one that is calculated with almost no transparency and notice-and-comment process.

This year’s stress test scenario surpasses the severity of any recession since World War II, including the global financial crisis of 2007-2009. Given that the industry has just endured a real stress test, we appreciate the Federal Reserve’s decision not to introduce additional macroeconomic scenarios in this year’s stress tests. The Fed’s severely adverse scenario properly illustrates the effects of a highly severe recession, leading to substantial capital depletion for most participating banks. Conversely, a realistically framed scenario featuring rising interest rates, coupled with less marked economic and asset price declines, would lead to less capital depletion than the existing scenario, adding little new insight to the overall results. The examination process seems to be the most effective safeguard against interest rate risk, and we anticipate the development of improved guidance for this process.

To learn more, check out our new webpage dedicated to stress testing here.

Recommended Read: Bloomberg’s Matt Levine offers one of the most coherent takes on the stress tests in a recent edition of his “Money Stuff” newsletter. Check it out here.

Five Key Things

1. Powell Cites Large Bank Strength as Bulwark in Recent Turmoil

Federal Reserve Chair Jerome Powell offered views on the spring bank turmoil in a speech this week. He warned against the tendency to “fight the last war” – after the global financial crisis, the regulatory system has focused on the danger of credit losses in the banking system. But instead, SVB’s demise stemmed from interest rate risk and a vulnerable business model, he said.

• Next steps: The turmoil suggests a need to strengthen supervision and regulation of banks the size of SVB, Powell said. “I look forward to evaluating proposals for such changes and implementing them where appropriate,” he said. “Much will depend on getting the specifics right, and we should bear in mind that there are always tradeoffs in any financial regulation.”
• Worth noting: “Of course, any rule change will go through the standard rulemaking process, including public notice and comment, and have appropriate phase-in and transition periods,” a footnote to the speech read. This sentiment is particularly relevant as the banking agencies prepare to release a Basel capital proposal.
• Large bank strength: Powell observed “the value of having the very largest banks be highly resilient.” GSIBs are “subject to capital surcharges, required to be highly liquid, and held to the highest supervisory standards,” Powell said. “The events of the past couple of months would have been much more difficult to manage had the largest banks been undercapitalized or illiquid.”

2. What Regulators Should Consider When Rethinking Liquidity Rules Post-SVB

Liquidity has taken a back seat to capital and other topics on regulators’ priority list in recent years. The most recent major changes to banks’ liquidity rules formed a framework including the net stable funding ratio, liquidity coverage ratio and internal liquidity stress tests (for U.S. banks). After policymakers put this framework in place, they focused most of their attention on other topics, such as Basel capital changes, M&A review and consumer protection rules. But liquidity is now back on regulators’ radar after liquidity risk contributed to bank failures this spring, and potential changes to the framework have emerged in public remarks and reports. A new BPI blog post explores how policymakers could invite stakeholder input on such changes.

• Possible changes: The potential revisions to liquidity requirements vary widely and include
  • reevaluating the stability of uninsured deposits – and the treatment of “held to maturity” securities – in liquidity rules and internal liquidity stress tests
  • applying standardized liquidity requirements to a broader set of banks
  • intensifying resilience requirements for large banks with respect to capital and liquidity
  • requiring additional liquidity beyond regulatory requirements for a bank with inadequate capital planning, liquidity risk management or governance and controls.
• What comes next? The wide range of changes under consideration calls for public input into the process at an early stage. The banking agencies should launch a formal advance notice of proposed rulemaking or a request for information. These steps open the door to public feedback from a broad set of stakeholders on the relative costs and benefits of any potential changes.
• The stakes: Public input is particularly important because of the potential costs of liquidity framework overhauls. Steps such as requiring more high-quality liquid assets – assets like Treasuries that banks must hold on their balance sheets to meet regulatory requirements – could weigh down banks’ books with less space to lend to consumers and businesses. Research shows that compliance with the NSFR and LCR, two key liquidity measures, reduce economic output and bank credit, respectively. These findings demonstrate the delicate balance regulators must strike between promoting financial stability and preserving banks’ role as engines of economic growth.
• Bottom line: A holistic review of liquidity standards would be a welcome step, so long as it includes robust opportunities for public input, such as through an Advance Notice of Proposed Rulemaking, and careful consideration of the costs of potential changes. 

3. EU Reaches Provisional Agreement on Basel Implementation

The European Union this week reached a provisional agreement on Basel bank capital implementation. Policymakers agreed on how to implement the “output floor” for bank capital and made changes to credit risk, market risk and operational risk. The provisional agreement also includes stipulations for crypto assets and banks’ management of ESG risks, and restrictions on banks’ use of internal models to calculate capital requirements.

• Translating changes: The U.S. is expected to propose a Basel implementation rule this summer. Any differences between the U.S. version and the EU implementation could have implications for global banks and the cost of loans across borders. The devil is in the details – small changes in the way the agreement is interpreted could make a significant difference. Historically, the U.S. has been inclined to inflate the internationally agreed capital requirements with its own additional layers, such as the Collins Amendment.
• First mover: The EU is reaching agreement on implementing the revised standards ahead of the U.S. and the U.K.

4. Bowman Casts Doubt on Need for More Capital

Federal Reserve Governor Michelle Bowman expressed concern in a recent speech with calls for higher capital requirements. As policymakers contemplate changes to the regulatory framework after recent failures, some changes, such as “a renewed examination focus on core banking risks” and “a careful review of liquidity requirements and expectations,” could be warranted, Bowman said – but “other reforms may be based on faulty assumptions or incomplete information.” Bowman cautioned that “new capital requirements could unnecessarily hinder bank lending and diminish competition.” Policymakers must consider whether examiners have the appropriate tools to identify key problems and demand prompt solutions, she said. “Increasing capital requirements simply does not get at this underlying concern about the effectiveness of supervision.”

• Tailoring: Bowman addressed allegations that recent bank stress was due to tailored regulatory requirements and a lax approach to supervision. “I have not seen compelling evidence to support this,” she said.
• State of play: Banks are much better capitalized with more liquidity and subject to a range of supervisory tools compared to the global financial crisis era, she said. “The underlying strength and resilience of the banking system also begs the question—what are the justifications for higher capital requirements?”
• Fresh look: Bowman reiterated her call for an independent review of the events surrounding recent failures. “The diagnosis of what went wrong can help inform necessary changes to supervision and regulation, the Fed’s emergency authorities and liquidity tools, and the resolution, auction, and insurance processes of the Federal Deposit Insurance Corporation (FDIC),” she said. “Misperceptions and misunderstandings about the root causes and related issues could result in changes that are not only unnecessary but result in real harm to banks and their customers, to the financial system, and to the broader economy.”
• Basel preview: Bowman noted the upcoming release of a Basel proposal. “I intend to approach the proposal with an open mind, as we consider taking appropriate and measured steps to reform the U.S. capital framework,” she said. “I support providing sufficient time, of at least 120 days, for industry and stakeholders to review and provide comment on the proposal.” She called for policymakers to be mindful of differences in implementation across jurisdictions, particularly the U.S. tendency to layer on its own requirements on top of Basel standards. Any deviation that makes U.S. requirements more stringent than global peers could have competitive implications for international banking, she said.
• Transparency: Bowman called for the Federal Reserve Board to return to holding more public open meetings on important matters.
• Financing dynamics: Higher capital requirements can push financing into the nonbank sector, leaving banks less able to compete, Bowman noted. “Rising bank capital requirements may exacerbate the competitive dynamics that result in advantages to non-bank competitors and push additional financial activity out of the regulated banking system,” she said. “This shift—while possibly leaving a stronger and more resilient banking system—could create a financial system in which banks simply can’t compete in a cost-effective manner.” Higher capital requirements can also lead banks to pull back from certain lines of business. Banks could retreat from market-making, she suggested, and funding could dry up for community infrastructure projects funded by muni bond issuance.

5. Bank M&A Debate Revived by Spring Stress, Policymaker Comments

Recent policymaker commentary and the spring banking turmoil have reignited the bank merger policy debate. This week, Sen. Elizabeth Warren (D-MA) criticized recent comments by Treasury Secretary Janet Yellen and Acting Comptroller Michael Hsu signaling some level of openness toward bank M&A in the wake of the spring failures. “This would represent exactly the wrong approach,” Warren said in a letter to Yellen, Hsu, the Fed’s Michael Barr, the Department of Justice’s Jonathan Kanter and the FDIC’s Martin Gruenberg. The letter decried the prospect of bank “consolidation” and asked the officials a series of questions, including when they will release updated merger review guidelines, the role of branch divestitures as a condition of merger approval and how updated guidelines will handle various evaluation criteria.

• The letter refers to “regulators’ practice of rubber stamping merger applications.” BPI has noted that the “rubber stamp” concept in bank M&A is a misconception — banks understand the high standards expected to obtain approval and tend to seek mergers only if they meet those standards.  Moreover, banks often opt to withdraw applications that may not receive timely approval prior to formal decisions, so denials are rare. (Recently, certain merger applications have languished during the review process – a trend that frequently has harmful side effects for customers and employees of affected institutions.) A more detailed analysis demonstrates that bank M&A regulatory review is a deliberating, rigorous process.
• DOJ: Kanter recently gave a speech that outlined a broader, and more bespoke, process for competition analysis of bank deals.

In Case You Missed It

‘Earned Wage Access’ Products Come With Risks to Consumers

Earned wage access products – fintech tools that offer advances on paychecks – advertise themselves as free of interest charges, but can come with APRs that rival payday loans, according to a recent Bloomberg piece. The average APR of these products is 334% for advances that request “tips” and 331% for those that don’t. Payday loans’ average APR is an eye-watering 353%, according to the article. The California Department of Financial Protection and Innovation is eyeing new restrictions on these products to treat them more like traditional loans.

• Bottom line: The high rates, and the risk of becoming looped into a cycle of borrowing, raise alarm, given that a target audience of these apps is lower-income workers living paycheck to paycheck. (A Walmart-backed fintech venture acquired an earned wage access provider to offer the service to the retailer’s employees.)

Private Credit’s Growing Reach into Blue-Chip Companies

Nonbank lenders such as Apollo, KKR and Blackstone have moved beyond their traditional province of higher-yield debt financing into investment-grade credit, according to the Financial Times this week. Deals with AT&T, PayPal and similar big-name companies demonstrate the growing reach of private credit into markets that were once dominated by investment banks.

• BlackRock: Meanwhile, BlackRock debuted a Private Credit Fund targeting mom-and-pop investors. The fund focuses on floating-rate loans to middle-market private U.S. companies, “an area that’s expected to grow as banks rein in lending,” Bloomberg reported this week.
• Big picture: The growth of private credit (and private equity) is a key part of the backdrop as policymakers consider raising capital requirements for banks. Higher costs of doing business would only serve to push even more financing into less regulated nonbank firms.

BPI’s Paridon Joins Bankshot Podcast 

BPI SVP and Senior Associate General Counsel Paige Pidano Paridon joined the American Banker Bankshot podcast in an episode aired this week to discuss the state of crypto and banking regulation. The episode also featured TD Cowen analyst Jaret Seiberg, reporter Jacob Silverman and George Washington University law professor Arthur Wilmarth. Topics discussed include regulatory lawsuits against Binance and Coinbase, the state of the crypto sector after the FTX collapse and the future of crypto oversight. Using blockchain-based technology within the regulatory perimeter of the banking sector can benefit consumers, Paridon said. “BPI members are keen to research and develop the use of the technology to bring the benefits that come with distributed ledger or blockchain-based technology that there seems to be some level of demand for” within the regulatory perimeter of the banking system, she said. “For example, exploration around blockchain-based deposits and token-based deposits. At the end of the day it doesn’t seem like it was the use of the technology that brought down FTX … it was just a number of other things including fraud, misappropriation of customer funds, et cetera.”

Some Sound Advice from the BIS

The Bank for International Settlements is not only a provider of financial services to central banks and the home of the Basel Committee on Banking Supervision, it is also a think tank on central banking. On Sunday, June 25, 2023, it just released its Annual Report. The chapter on monetary and fiscal policy concludes with the following advice for central banks:

Careful consideration should also be given to keeping central bank balance sheets as small and as riskless as possible, subject to delivering successfully on the mandate. This would have three benefits. First, it would limit the footprint of the central bank in the economy, thereby reducing the institution’s involvement in resource allocation and the risk of inhibiting market functioning. Second, it would lessen the economic and political economy problems linked to transfers to the government. Finally, it would maximise the central bank’s ability to expand the balance sheet when the need does arise. Given the costs of large and risky balance sheets, the initial size is a hindrance, not an advantage. The balance sheet needs to be elastic, not large.  p. 69

The advice seems to be aimed at least in part at the Federal Reserve. Before the Global Financial Crisis, at the end of June 2007, the Fed’s balance sheet was 6 percent of U.S. GDP. Now it is 32 percent. It owned $800 billion in Treasury securities then; now it owns over $5 trillion in Treasury securities and $2.5 trillion in mortgage-backed securities. It conducted monetary policy by engaging in relatively small ($20 billion) repo operations with a handful of primary dealers. Now it conducts daily reverse repos for $2 trillion with hundreds of money market mutual funds, GSEs and foreign official institutions. Its operations resulted in banks holding $16 billion in reserve balances (loans to the Fed); that number is now $3.2 trillion.

When the BIS says a “riskless” balance sheet, it is referring to interest rate risk, and when it says “political economy problems linked to transfers to the government” it means losing huge amounts of taxpayers’ money.

The Crypto Ledger

PayServices Bank sued the San Francisco Fed over the Reserve Bank’s denial of the fintech’s bid for a master account. PayServices, a trade finance fintech, applied for a master account last year after receiving preliminary approval from Idaho for a state banking charter. But the San Francisco Fed denied its application in May. PayServices contends that the decision jeopardized its business plans and violated administrative law and the firm’s due process rights. The Fed also faces a lawsuit from Custodia, a Wyoming crypto firm, over similar issues. Here’s what else is new in crypto.

• FTX reboot? Collapsed crypto exchange FTX is looking to rise from the ashes, according to a Wall Street Journal piece this week. The exchange has started soliciting interested parties to reboot the exchange, according to its CEO John J. Ray III, who took over as the firm filed for bankruptcy. Fintech firm Figure has indicated interest in helping support a restart of FTX, according to the article. While rebooting the bankrupt company can sometimes be beneficial to customers in bankruptcies, FTX has a tough road ahead, including replenishing misappropriated customer funds and navigating a stringent regulatory environment. Here’s what else is new in crypto.
• Coinbase responds: Coinbase provided its first legal reply to the SEC, which is suing the exchange over alleged securities law violations. Coinbase claimed that crypto assets listed on its platform fall outside the SEC’s purview – the firm claimed the relevant assets were not investment contracts and therefore not securities.
• Digital euro: Mairead McGuinness, the European Commission’s point person on financial services, published a Financial Times op-ed this week making the “case for a digital euro.” McGuinness laid out the potential benefits of the digital euro, such as its ability to be used anywhere in the eurozone and its potential to reach the unbanked. She also acknowledged concerns, such as privacy. “We’re safeguarding cash as an accepted form of payment,” she said. “But we also want to offer people an extra choice. So second, we will propose a law to allow the ECB to issue a digital euro, if it decides that would be worthwhile and workable. The digital euro would be a complement to cash, not a replacement.”
• Binance: Binance’s links to the global banking system are dwindling. The crypto exchange’s euro banking partner, Paysafe Payment Solutions, will stop supporting it after Sept. 25, according to CoinDesk.

CIBC Supports Cycling Fundraiser for Childhood Cancer Research

CIBC last week announced its official partnership with the Tour CIBC Charles-Bruneau, a cycling event to raise funds for pediatric cancer research. The event is the flagship fundraiser for Fondation Charles-Bruneau.