BPInsights: July 15, 2023 - Bank Policy Institute

The Holistic Review That Wasn’t

This week, Federal Reserve Vice Chair for Supervision Michael Barr gave a speech on, in lieu of releasing a “holistic review” of, U.S. capital standards. A new BPI analysis highlights nine omissions and errors in the speech that suggest the speech failed to consider several important issues and reached policy conclusions unsupported – or contradicted – by facts. The speech presented no data, analysis or citations in support of its conclusions, and appears to raise more questions than it answers.

Among these errors and omissions are:

1. Lack of full consideration of both costs and benefits: Vice Chair Barr’s speech largely dismissed the costs of higher capital requirements – higher costs for banks to lend and to intermediate in capital markets, leading to lower economic growth. These costs are supported by academic research. The Basel Committee itself found in a recent literature review that a 1-percentage-point increase in capital requirements decreases annual GDP by up to 16 basis points (about $42 billion of output lost per year).

By this measure, Vice Chair Barr’s intended proposal would reduce annual U.S. GDP by more than $80 billion each year.
The Vice Chair’s assertion that extending the phase-in period for these changes would soften their impact is not consistent with the reality of business planning, or demands of the investor community. Companies, including banks, make plans based on the future regulatory environment and will therefore bake in the costs of higher capital requirements to their business planning long before the effective date of the rules.

2. Holistic or atomistic? Barr had previously promised that the holistic review would look at how the various U.S. capital requirements interact with each other as well as other regulatory requirements, and what their cumulative effect is on the financial system. Yet this week’s speech includes no consideration of the interaction of capital standards with other related rules, including liquidity regulation, total loss absorbency requirements, resolution/recovery planning rules and margin requirements and other derivative rules.

3. The law on tailoring: Barr said he will recommend that the enhanced capital rules apply to banks with $100 billion or more in assets. The speech disregards important elements from the statute on the tailoring of regulatory requirements. Section 165 of the Dodd-Frank Act directs the Federal Reserve to consider a range of factors when deciding whether and how to apply enhanced prudential standards to certain banks. It requires that the Fed “shall differentiate among companies on an individual basis or by category” – rather than saying that all the same standards should apply to all of these firms.

4. The wrong SVB lesson: Changes from the Basel agreements in 2017 and 2019 center on credit risk, operational risk and market risk, not the core risks (liquidity and interest rate risk) that brought down Silicon Valley Bank. Vice Chair Barr seems to suggest that banks holding much more capital for cyber attacks, trading losses and loan defaults is an answer to SVB’s asset-liability mismatch and depositor concentration. The risks that caused SVB’s failure and the risks addressed by Basel simply do not align.

Looking forward: With the process of analyzing the interaction of various regulations and the cost of adding new requirements to them apparently still undone, there is a strong case for the federal banking agencies issuing any thoughts on the 2017 Basel agreement as an advance notice of proposed rulemaking rather than a proposed rule, with an extended comment period. Only in that way can some of the issues that the “holistic review” was advertised to cover be considered prior to a formal proposal.

Five Key Things

1. Quarles: Stress Tests Are ‘Illegal’

The Federal Reserve’s stress tests are “illegal” as they’re currently run, former Vice Chair for Supervision Randal Quarles said this week. The pronouncement is a stunning indictment of the opacity of the stress tests, given Quarles’ former position overseeing them. “I have become convinced that the way the stress test is conducted now is a violation of the Administrative Procedure Act – it is illegal,” Quarles said at a SIFMA event this week.

Context: The Fed’s stress tests rely on nonpublic models to set binding capital requirements, in a departure from the norms of government transparency. This fact was at the heart of Quarles’ criticism.
“More than illegal”: At the same event, Quarles said significantly raising bank capital requirements was “a mistake” and “will restrict the ability of the financial system to provide support for the real economy.” Plans to significantly increase capital requirements could exacerbate the legal problem with stress tests: “I worry now with the further interaction of the improperly, the illegally run, stress test with the extreme upward calibration of the through-the-cycle capital requirements, that it may be more than illegal. It may be an excessive delegation of authority to the Federal Reserve and may be unconstitutional given some of the recent Supreme Court decisions.” This is an apparent nod to the Supreme Court’s major questions doctrine, which is a principle of statutory interpretation pursuant to which courts will presume that Congress does not delegate to executive agencies issues of major political or economic significance, absent clear congressional authorization.
Stepping back: Quarles said he believes in the concept of stress testing, but the Fed’s current approach to them is a legal violation. There are ways for the Fed to conduct the tests “that can comply with the law,” Quarles said.

2. The Costs of Higher Capital Should Count

The American Bankers Association, Bank Policy Institute, Financial Services Forum and Securities Industry and Financial Markets Association this week expressed concern in a letter to Federal Reserve Chair Jerome Powell about a forthcoming proposal to implement the Basel agreement of 2017. The way that U.S. policymakers implement this agreement will drive capital requirements for banks and affect how they do business. A significant increase in those requirements – as previewed in a speech by Vice Chair for Supervision Michael Barr announcing the “results” of his “holistic review” of U.S. capital rules – will have immediate, lasting consequences for how they finance the U.S. economy.

The trades wrote: “This rule will have a profound effect on the U.S. banking system and U.S. capital markets. This will have a direct impact on the ability and cost of businesses and individuals to obtain credit and capital and manage business risks. It merits careful consideration.”

The trades highlighted two fundamental flaws with Vice Chair Barr’s speech:

The holistic review, in the form of Barr’s speech, which was never formalized or made public, considered only the benefits of higher capital requirements, not the costs, which are universally recognized and significant.
The speech claimed that there was a “consensus” among Basel jurisdictions that current rules underestimate risk for the largest, most complex banks. But the Basel Committee concluded that the changes in the 2017 agreement would lead to lower risk-based capital requirements of all large, internationally active banks in the big picture.
- Central bankers behind the agreement noted that its goal was not to increase capital in the aggregate, and instead to level the playing field among global banks.

Bottom line: Given the substantial implications for bank credit in the U.S., including for small businesses, the proposal necessitates a thorough cost-benefit analysis and a comment period long enough for deep review.

3. Postmortem on the 2023 Stress Test Results

A recent BPI note makes observations about this year’s Federal Reserve stress test results, which were released June 28. The note highlights significant limitations of these supervisory projections. These limitations make bank-level results more volatile and capital requirements less stable, which makes it harder for banks to manage their capital from year to year.

Transparency: A bank’s performance in the stress tests directly affects its capital requirement, so the Federal Reserve should be transparent about how it calculates stress losses and revenues for banks. Transparency enables banks to make informed, efficient decisions on their balance sheets and capital that take supervisors’ views of risks into account.
Other challenges: A meaningful update is necessary in how the Federal Reserve projects pre-provision net revenue, or PPNR. The current approach relies heavily on a bank’s recent performance to determine its performance in stress tests under the severely adverse scenario. This approach undermines the reliability of the results as the stress scenario may be very different from actual economic outcomes.
The Fed should also use a more robust methodology to project certain components of regulatory capital (e.g., AOCI), in order to better capture differences in risk profiles of individual banks.
Results snapshot: The stress tests project a maximum decline in the common equity tier 1 (CET1) capital ratio of 2.3 percentage points, a decline about 40 basis points lower than last year’s. These findings highlight the impact of the more severe stress test scenario, the variations in PPNR projections among different bank groups, the reduction in unrealized losses on investment securities and the lower losses associated with the global market shock and other factors.
Key observations:
- Changes in PPNR models for intermediate holding companies led to a highly significant reduction in revenues for those banks.
- Supervisory PPNR projections assign disproportionate importance to bank performance in the preceding year.
- The Fed’s own projections of unrealized gains/losses on investment securities is more sensitive to changes in interest rates than banks’ own forecasts.
- There was even less transparency in the reporting of operational-risk losses this year.
- Banks project lower loan losses than the Fed but also anticipate higher reserve builds.
Why it matters: Volatility in capital requirements from stress test projections pose a significant challenge to banks managing their balance sheets and their business. To ensure banks can finance the growth of the economy, they must have clear, consistent expectations of how stress tests affect their capital requirements over time.

4. Lawmakers Call for Transparency on Capital

A bipartisan pair of lawmakers urged the Federal Reserve’s Michael Barr in a recent letter to provide details to Congress on his holistic capital review and upcoming proposal on the Basel agreement. Reps. Andy Barr (R-KY) and Bill Foster (D-IL) called on Vice Chair Barr to give details and analysis underpinning the review and the upcoming proposal before any notice of proposed rulemakings, and to testify on planned Basel changes and the holistic capital review. “With heightened inflation and threats to our mid-term economic outlook, Americans worry about accessing credit for mortgages, cars, small businesses, and everyday living expenses,” the members of Congress wrote. “Your holistic review and any new requirements should consider those concerns to minimize negative impacts as we enter a phase of potential credit tightening. We must strike the right balance between safeguarding our financial system and ensuring banks of all sizes can support communities’ access to credit.”

5. Why Scale in Banking Matters

BPI this week submitted a statement for the record to the Senate Banking Committee’s Subcommittee on Economic Policy for Wednesday’s hearing entitled “Bank Mergers and the Economic Impacts of Consolidation.” Bank M&A enables scale that benefits consumers, and the need for clear bank merger policy that supports a robust banking system is more salient in light of recent banking stress, BPI said in the statement.

“Just as taking preventive steps to strengthen a healthy patient is preferable to emergency surgery, mergers between healthy banks are better than eleventh-hour transactions in a failure. Openness to bank M&A among top policymakers is necessary to ensure the banking system remains healthy even under stress and continues to meet the needs of customers.”

It is encouraging to see some policymakers expressing openness to bank M&A, but this message conflicts with signals from other officials, the statement said. In addition to acknowledging the potential benefits of M&A, policymakers should provide clear expectations and timelines for merger approvals, as lengthy delays can impose tangible costs on bank customers, employees and investors, it said.

Bottom line: “We encourage the Subcommittee to consider the economic benefits of bank M&A and the costs of precluding it,” the statement said. “A predictable path forward for bank mergers promotes a healthier banking system and a more stable U.S. economy.”

In Case You Missed It

Fed Nominees Move Forward in Senate

The Senate Banking Committee advanced three Federal Reserve nominations this week. Vice Chair nominee Philip Jefferson and Board nominees Adriana Kugler and Lisa Cook received approval from the panel, putting them one step closer to confirmation. The next step will be a Senate floor vote.

A New Way to Move Money

Last week, a diverse group of payments industry participants from both the public and private sectors announced the findings from the Regulated Liability Network (RLN) U.S. Proof of Concept. Paige Pidano Paridon, senior vice president and senior associate general counsel, issued the following statement in response:

The success of Phase 1 of the RLN demonstrates the ability of the regulated financial system to innovate while maintaining stability and dollar supremacy as well as safeguarding against risks like illicit finance. Novel payment methods, like central bank digital currencies and unregulated stablecoin alternatives, remain costly distractions.

What’s the purpose of the RLN?

The RLN is a theoretical project to determine whether shared blockchain technology could be applied to all regulated monies (e.g., central bank money, commercial bank money and e-money) on a common platform. Phase 1 served as an initial 12-week effort between the Federal Reserve Bank of New York’s Innovation Center and a collection of technology firms, banks and payment service providers. The collaboration examined the viability from a legal, technical and business perspective.

The RLN is unlike CBDC. Here’s why:

CBDCs are a liability of the central bank and would disintermediate the private sector. A CDBC would shift money out of bank deposits and into cash – the equivalent of consumers keeping money under their mattresses – and reduce banks’ ability to lend. While supporters of a U.S. CBDC tout its purported benefits, such as furthering financial inclusion and preserving the U.S. dollar as the global reserve currency, there is no evidence supporting these assertions.

Unlike a CBDC, the RLN would maintain the current respective roles and benefits of central bank money and commercial bank money while enhancing their capabilities to improve payment efficiency.

In Safe Financial Data Sharing, the Private Sector Leads the Way

As the CFPB drafts new rules for how consumers can access and share their financial data, it should keep in mind the wave of private-sector-led innovation that has proliferated in recent years and enabled consumers to share their data safely. A key conduit for this innovation is the Financial Data Exchange, a nonprofit organization composed of more than 200 stakeholders of various sizes, including banks, fintechs, data aggregators and consumer and industry groups. FDX has promoted standards that empower consumers to exercise control over their financial data.

Key point: FDX standards ensure data is shared safely and securely, with consumer protection and privacy at the forefront.

Context: The CFPB is crafting data-sharing rules under Section 1033 of the Dodd-Frank Act. The Bureau outlined what a potential rule could look like last October, which raised concerns that it could take an overly prescriptive approach to the rulemaking. More recently, CFPB Director Rohit Chopra made a welcome clarification that strict requirements would slow progress and the optimal rule “should provide a high-level structure within which market participants can create granular standards and requirements.” He also highlighted that “many of the details in open banking will be handled through standard-setting outside of the agency [,which] . . . . can allow open banking to evolve as new technologies emerge, new products develop and new data security challenges arise.”

Bottom line: As the CFPB moves toward a final rule, it’s critical that they avoid excessively prescriptive policies that could undermine the significant innovation led by the private sector. The CFPB should leverage existing private-sector standard-setting efforts that have demonstrated effectiveness in securely sharing consumer financial data.

CFPB Must Resolve Hastily Crafted, Overreaching Policy on Abusive Acts or Practices

A broad coalition of financial services trade associations submitted comments on July 3 to the Consumer Financial Protection Bureau on its Policy Statement governing abusive acts or practices. The associations, including BPI, the American Financial Services Association, Consumer Bankers Association, Credit Union National Association, Mortgage Bankers Association and the U.S. Chamber of Commerce, expressed concern with the CFPB’s hasty approach to this policymaking, its deviation from statutory requirements and its failure to provide clear guidance regarding abusive acts or practices.

“Responsible providers already take steps to identify and avoid practices that may be unfair, deceptive or abusive, and federally-regulated financial institutions have extensive compliance management systems specifically to monitor for such conduct,” the coalition wrote. “By identifying conduct that may be abusive because it is more egregious than conduct that is solely unfair or deceptive, the Bureau will enable institutions to better calibrate compliance systems, change practices and better protect consumers.”

The Crypto Ledger

Former Celsius Network CEO Alex Mashinsky was arrested this week on several charges including wire fraud. The arrest came a year after the crypto lender filed for bankruptcy, and marks the latest fall from grace among crypto moguls. Here’s what else is new in crypto.

FTC settlement: The Federal Trade Commission this week announced a settlement with Celsius that will permanently ban the platform from handling consumers’ assets. The agency also charged three former executives with tricking consumers into transferring crypto onto the platform by making false promises that deposits would be safe and always available.
Ripple glass half-empty: Ripple succeeded in part of its SEC enforcement case this week as federal judge Analisa Torres agreed with the crypto firm’s argument that roughly half its sales of token XRP did not constitute an illegal securities offering. Torres ruled partly for the SEC, saying the other half of Ripple’s sales did constitute an illegal securities sale. The case could have implications for the SEC’s crackdown on Coinbase and Binance. The agency has repeatedly said most crypto tokens are securities.
Former FTX exec under investigation: Former FTX executive Ryan Salame and his girlfriend, former Congressional candidate Michelle Bond, face a probe from New York federal prosecutors over potential campaign finance law violations, the Wall Street Journal reported. Investigators are probing whether the couple illegally skirted federal limits on contributions to Bond’s 2022 campaign for the GOP primary for New York’s First Congressional District.
Binance exodus: Binance is losing senior staff in response to CEO Changpeng Zhao’s handling of regulatory probes of the crypto exchange.
Digital ruble: Russia will begin testing a digital ruble with consumers in August, according to Reuters. A key difference between Russia’s quest toward digital money and other countries’: the raft of sanctions encircling the nation and its currency. It’s therefore unlikely that a digital form will raise the ruble’s clout in global markets.

AI Rules Should Focus on Outcomes, Not Technology

BPI submitted a comment letter last week on the White House Office of Science and Technology Policy’s request for information on artificial intelligence. As policymakers and the industry evaluate the transformative potential of this technology, the public sector should focus on regulating AI outcomes rather than technology itself, the letter said. “The financial industry strongly believes that it is important to regulate AI outcomes rather than the technology itself,” the letter said. “We endorse the notion that leveraging existing regulatory frameworks, which have evolved through decades of experience and are time-tested, is both efficient and imperative. The existing regulatory framework and robust risk management practices of banks have historically accommodated emerging technologies like machine learning, a type of AI, and the same is true for banks’ implementation of AI technologies. We support the responsible adoption of AI, fortified by strong governance, comprehensive risk management, and vigilant oversight, with focus on the core tenets of transparency, compliance, and social implications.”

Bonnafé Profiled in Financial Times Article

BNP Paribas CEO Jean-Laurent Bonnafé was profiled in a Financial Times piece this week, which focused on the bank’s longevity and various challenges ahead, such as the climate transition. “The bank was incorporated in 1848 and is here to stay for a very long period of time,” Bonnafé said in the article. “This is a team.”

Dimon Offers Views on Big-Picture Global Challenges with The Economist

In a recent video interview with The Economist, JPMorgan Chase CEO Jamie Dimon weighed in on China, Ukraine and other important topics for the global financial system. Watch the interview here.