BPInsights: July 15, 2022

Stories Driving the Week

Misunderstanding the Fed’s Stress Test: Costs & Consequences

A new BPI blog post published this week explains how the Fed’s bank stress test operates, how it affects the economy, and how those effects are widely misunderstood and underestimated.

Why it matters: A clear view is important given the economic importance of that test, and the significant problems with its operation. The economic importance derives from the fact that increases in bank capital requirements reduce lending and economic activity. Also, the stress test is not neutral across asset classes and is particularly punitive to two: lending to low- and moderate-income households and small businesses.

In addition, the post explains why this single stress test is seriously flawed as a measure of bank risk under stress on multiple counts. Markets do not respond the way the global market shock projects; expenses do not grow along with assets, particularly riskless ones; operational risk has not produced the massive losses the test presumes. Most fundamentally, the use of a single stress test requires the Federal Reserve to add up the worst-case scenario for a variety of risks even when those risks are not correlated or are negatively correlated; the result is a punitive capital charge.

What to do about it: The flaws of the stress tests are costly because banks adjust their balance sheets to maximize returns to shareholders, and that includes exiting or raising prices for businesses that carry uneconomic capital charges. Policymakers should not be confused about why business and mortgage lending have become predominantly a nonbank product and the buy side bemoans a lack of market liquidity. It’s time for policymakers to start connecting the dots.

The FDIC’s Proposed Increase in Deposit Insurance Assessments May Be Based on Incorrect Projections

The FDIC published a proposal to increase sharply the assessments banks pay for deposit insurance on June 21, 2022. The assessments are used to build up a reserve that is in turn used to cover losses from insured bank failures. The proposal was prompted by the fact that the ratio of reserves to insured deposits (the “reserve ratio”) had fallen to 1.23 percent, and the FDIC is required by law to maintain a minimum ratio of 1.35 percent or, if short of that target for any reason, adopt a plan to return to the minimum within eight years of the plan’s adoption. Because the FDIC had adopted a plan in September 2020, shortly after the ratio first fell below 1.35 percent, it needs to return the ratio to 1.35 percent by September 2028. The proposal was premised on FDIC analysis indicating that the reserve ratio would not return to 1.35 percent until between the second quarter of 2027 and the third quarter of 2034, depending on the assumptions made, and that the FDIC was therefore at risk of failing to meet its statutory deadline.

What BPI is saying: In this note, BPI replicates the FDIC’s projections and then changes two assumptions. First, whereas the FDIC assumes that interest earnings and capital gains will be zero over the forecast horizon, we assume that, starting in 2022Q3, they will sum to 2½ percent, which is roughly where rates are now and the Federal Open Market Committee’s outlook for the overnight rate over the longer term. Second, whereas the FDIC assumes that deposits will grow at 3½ or 4 percent, we assume that the level of deposits will remain unchanged in the medium term, in line with the fact that deposits are currently contracting and that the factors that have boosted deposits over the past few years have all reversed.

Each of these changes shifts significantly earlier than the projected date that the DIF reserve ratio will reach 1.35 percent, and together they move the projected date to the third quarter of next year. For example, using the FDIC’s most pessimistic assumptions and simply assuming that interest earnings and capital gains will be 2½ percent of reserves instead of zero moves the projected date for reaching a 1.35 rate nearly nine years earlier than the FDIC’s projection, from 2034Q3 to 2025Q4. If, in addition, deposits are assumed to hold steady at their 2022Q1 level (and they are probably already below that level), the reserve ratio reaches 1.35 percent in the third quarter of next year rather than the third quarter of 2034.

How to fix it: In short, the FDIC appears not to have taken into account the significant changes that have taken place this year with respect to interest rates and deposits and the outlook for those variables. If the FDIC’s projections are adjusted for those changes, the reason it proffers for such a sharp increase in assessments evaporates. Rather than doing poorly, the FDIC’s reserve-ratio restoration plan is performing well. The FDIC reassesses the performance of its plan every six months. The Corporation should table its proposed increase and reconsider the situation six months down the road.

The Crypto Ledger

  • Binance ignored U.S. sanctions. Crypto exchange Binance enabled Iranian traders to evade sanctions imposed by the United States, according to reporting by Reuters. The sanctions were enacted in 2018, however, many traders continued to use Binance to circumvent U.S. law up until September 2021 when the company finally took measures to fully enforce AML/KYC standards. Binance has also reportedly served as a service for hackers, fraudsters and drug traffickers.
  • Bankrupt: Celsius Network LLC. “Few are feeling OK about things… There was more risk in this than fully appreciated” stated one individual close to Celsius as the company fought to stave off bankruptcy late last month. The company relied on making loans without backing those loans with adequate reserves, and when in trouble, barred users from accessing their money. Celsius filed for bankruptcy on July 13, leaving many customers on the hook for significant losses.
  • Also bankrupt…and missing? Crypto hedge fund Three Arrows Capital filed for bankruptcy in early July after a rout in crypto markets wiped out significant portions of the company’s portfolio. Three Arrows Capital was estimated to have been holding between $200 million to $560 million in Luna, which became worthless practically overnight. As of July 12, company executives have reportedly been missing in an apparent attempt to dodge creditors
  • Treasury seeks comments on digital asset adoption. The U.S. Department of Treasury announced this week that it would begin accepting comments from the public on cryptocurrency. The announcement — a response to a March 2022 Executive Order — seeks to determine the usefulness of crypto and what safeguards are necessary.
  • BIS, International Monetary Fund and World Bank call for cooperation to achieve CBDC interoperability. A July 11 report encourages global central banks — including in jurisdictions like the United States where the benefits of a central bank digital currency remain unsupported — to cooperate and collaborate with one another early in the development process so that cross-border payments between jurisdictions can continue without significant barriers. According to reporting by CoinDesk, the report recommends five core criteria to account for as central banks consider a CBDC: Central banks must do no harm, enhance efficiency, increase resilience, assure coexistence and interoperability with other systems and bolster financial inclusion.”
  • Bank of England Deputy Governor thinks the time is now for crypto regulation. At an event hosted on July 12, Bank of England Deputy Governor for Financial Stability Jon Cunliffe called on regulators to take action to address the risks posed by cryptocurrency. He stated that while crypto has not been integrated into the whole of the financial system, those lines “increasingly become blurred.” Cunliffe also emphasized: “Financial assets with no intrinsic value … are only worth what the next buyer will pay. They are therefore inherently volatile, very vulnerable to sentiment and prone to collapse.”

BPI Supports CRA Lending Goals, Cautions New Proposal May Stray from the Law’s Core Mission

BPI submitted a written statement to the House Financial Services Subcommittee on Consumer Protection and Financial Institutions earlier this week as the Subcommittee considered potential reforms to the Community Reinvestment Act. The hearing examined a recent joint proposal by the banking agencies to modernize the CRA, the first interagency effort to implement major changes to the law since 1995.

What BPI is saying:

“BPI supports the goals of the CRA in encouraging financial institutions to meet the credit needs of the communities they serve, and we appreciate the agencies’ coordinated effort to update the rules implementing the statute. However, the current joint proposal is poorly calibrated, unnecessarily complex and could undermine the law’s core mission of better serving communities. The challenges are resolvable through the rulemaking process, and we encourage the agencies to continue collaboration with industry to help the rule better meet the goals of the CRA.” — Paige Pidano Paridon, BPI senior vice president and senior associate general counsel

Here’s the background: The Community Reinvestment Act was originally enacted in 1977, requiring the Federal Deposit Insurance Corporation, Federal Reserve and the Office of the Comptroller of the Currency to assess financial institutions’ records of meeting the credit needs of their communities, including low- to moderate-income neighborhoods. On May 5, 2022, the agencies issued a joint proposal to modernize the rule. This effort follows a previous rulemaking effort by the OCC, which was abandoned in July 2021.

Problems with the proposal:

  • The proposal is needlessly complex and, therefore, would fail to achieve one of the benefits of revisiting the rule in the first place — for banks and their CRA partners in the communities to understand what counts as CRA credit, and to create an efficient process for implementing it.
  • The proposed rule is poorly calibrated and would result in widespread downgrades of large banks and new barriers to achieving “outstanding ratings,” which could lead to reduced incentives to strive for such ratings, and thus, undermine the goals of the CRA.
  • Banks would be evaluated outside of their facility-based assessment areas; however, because it takes time and dedicated resources to build meaningful CRA infrastructure in a given geography, banks may be disincentivized from offering lending products in many places outside their facility-based assessment areas where they lack the resources. As a result, underserved communities could suffer from a constriction in the availability of credit, frustrating further the very purpose of the CRA.

House Passes 2023 National Defense Authorization Act. Next Up, Senate.

The U.S. House of Representatives voted 329-101 to pass the 2023 National Defense Authorization Act, an annual exercise providing funding to the military, national security agencies and other sectors of the U.S. government to defend against threats, including cyberattacks. An amendment to grant the Cybersecurity and Infrastructure Security Agency authority over designating companies as “systemically important entities (SIEs)” was among the many provisions in the legislation, proposed as an amendment by Representative Jim Langevin (D-RI) on Thursday evening. Companies that are designated as SIEs – typically considered vital to U.S. national security and a member of one of the 16 critical infrastructure sectors – would be required to adhere to heightened security requirements and receive priority access to certain government programs and assistance. The amendment is one of several recommendations proposed by the Cyberspace Solarium Commission, of which Rep. Langevin was a member, that was charged with providing recommendations for Congress to prevent and prepare for cyber threats. BPI has raised concerns with the amendment as drafted as it would expand government reporting requirements for firms designated as SIEs, requiring them to submit sensitive information to CISA without addressing the ongoing need for expanded collaboration between firms and the intelligence community to defend against national security threats. The legislation must now be considered by the U.S. Senate.

Senate Confirms Michael Barr as Federal Reserve Vice Chair for Supervision in Bipartisan Vote

The U.S. Senate confirmed Michael Barr as a member of the Federal Reserve Board of Governors —the final vacancy on the Board following the confirmation of Governors Philip Jefferson and Lisa Cook earlier this year — and as vice chair for supervision of the Federal Reserve in two separate bipartisan votes that took place on Wednesday. Barr will assume the role previously held by former-Vice Chair for Supervision Randal Quarles, whose term expired in October 2021, and will serve on the Fed Board until 2032. In this role, Barr will be responsible for establishing policy for the supervision and regulation of financial institutions.

In Case You Missed It

Drawing the Line on Consumer Protection

This week David Lott, a payments risk expert in the Retail Payments Risk Forum at the Atlanta Fed wrote a blog post outlining the legal responsibilities of financial institutions under Regulation E.  The post was in response to an article he read about a potential class action lawsuit against financial companies in situations where the consumer has authorized an immediate payment to a fraudster. The consumers believe they should be reimbursed by the financial institution because they were duped.

Lott writes, “Regulation E is quite clear on where the line is drawn as to the customer’s liability in an electronic transaction. If the transaction is unauthorized, the customer’s liability is generally zero as long as they report the transaction within a specified amount of time. The regulation is very specific in its definition of unauthorized: ‘an EFT from a consumer’s account initiated by a person other than the consumer without authority to initiate the transfer and from which the consumer receives no benefit.’ In the cases discussed in the article I read, the consumers admit that they voluntarily initiated the push payment transactions, so the financial institutions appear to be justified in denying reimbursement because the transactions did not meet the definition of ‘unauthorized’ and therefore the liability protections of Regulation E did not apply.”

Applying TLAC and Single Point of Entry Resolution Requirements to Regionals ‘Akin to Putting Square Peg in a Round Hole and Just Hammering at It’

American Banker reported this week on rumors that regulators may be considering modifying the resolution requirements for regional banks, outside of the formal rulemaking process, by requiring Total Loss Absorbing Capital (TLAC) and “single point of entry (SPOE)” resolution strategies. John Court, BPI executive vice president and general counsel, was quoted in the article emphasizing how these requirements would be incommensurate with the risks posed by regional banks.

GSIBs generally have material operations in numerous jurisdictions and big trading operations outside of their bank subsidiaries, and those two characteristics present resolution challenges that SPOE and TLAC resolve both elegantly and effectively. Importantly, those are not characteristics of large regional banks, and so SPOE and TLAC don’t make sense for those firms. Attempts to require it are akin to putting a square peg in a round hole and just hammering at it.

BPI has highlighted (see herehere and here) that this move by regulators would increase costs for borrowers, is unnecessary to promote financial stability, would produce no tangible public benefit and would raise serious procedural and fairness concerns if implemented without regard to the rulemaking process.

POLITICO Cybersecurity Highlights CISA Director Jen Easterly’s First-year Accomplishments

Eric Geller with POLITICO Cybersecurity outlined some of the many accomplishments of CISA Director Jen Easterly on July 13, marking the end of her first year in the role. Easterly has been instrumental in launching the Joint Cyber Defense Collaborative, coordinating with other government agencies to declassify and share information faster with critical infrastructure firms and has collaborated with industry to prepare for cyber-attacks and combat the growth of ransomware. The article also addresses several challenges that lay ahead, including broadening international partnerships, maturing its capabilities and determining the appropriate size and role of CISA as the demands on the agency increase.

Law360: Feds’ De-Risking Guidance May Not Move Needle at Banks

The Financial Crimes Enforcement Network recently issued a joint statement with the banking agencies attempting to clarify what types of business activities represent a high risk. Financial institutions must comply with strict anti-money laundering and countering the financing of terrorism laws and regulations, which when coupled with the exam environment, have compelled banks to apply a one-size-fits-all review process to maintain compliance for certain types of customers. As outlined in a Law360 article published this week, these regulatory expectations have resulted in scrutiny toward non-government organizations, foreign nationals, independent ATMs and other business types. The joint statement seeks to address some of the challenges by emphasizing a “risk-based approach” to compliance so that banks can base their reviews on the unique risk profiles of individual customers.

FT Details Quantitative Tightening

This week the FT published a deep dive on Fed’s approach to quantitative tightening. The article quotes BPI chief economist Bill Nelson who explains that the Fed will not use asset wind-downs to manage the economy.  “They don’t want anybody really thinking or talking about the balance sheet . . . In order to achieve the tightening objectives that they’re seeking, I don’t think they would ever do that with the balance sheet, ” Bill states in the article.

NIST Increasing Efforts to Engage International Stakeholders on Cybersecurity Framework 2.0

The National Institute of Standard and Technology is ramping up efforts to engage with international stakeholders, according to Inside Cybersecurity, as it seeks to develop the Cybersecurity Framework 2.0 — a voluntary compliance resource designed to help organizations around the world better understand regulatory compliance expectations and implement best practices. “NIST will be increasing its engagements, with outreach to foreign governments, multinational corporations, and international standards bodies. This includes participation in multilateral and bi-lateral discussions occurring typically on a weekly basis and leveraging strong partnerships with the Department of State and the International Trade Administration,” said Amy Mahn, NIST’s cyber lead. This effort follows a June 3 release summarizing comments received on the Framework in response to NIST’s request for information earlier in the year. The Cybersecurity Framework as well as the Cyber Risk Institute’s “Profile” are one of several tools used by America’s banks to stay ahead of global threats and safeguard their customers.

WSJ Op-Ed: The SEC’s Climate Rule Won’t Hold Up in Court

In a WSJ op-ed this week, Paul Atkins and Paul Ray write that the Supreme Court’s decision in West Virginia v. EPA spells trouble for the SEC’s climate disclosure rule.  “The SEC’s proposed climate disclosure rule would expand its authority in a way that is almost indistinguishable from the EPA’s failed attempt to seize more power than it was due. The SEC would be wise to retract and rethink its planned disclosure rule now,” Atkins and Ray write.

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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.