BPInsights: July 2, 2022

Stories Driving the Week

Deep Dive: DFAST 2022

This year’s DFAST results will raise capital requirements for large U.S. banks. However, some of these projected higher requirements are not explained by increased riskiness. Rather, they appear to be, in part, due to noise in the Federal Reserve’s net revenue projections that inflate projected expenses (including operational risk losses) of banks that received a large influx of deposits during the pandemic.

BPI expects the aggregate stress capital buffer to increase 40 basis points to 3.7 percent. GSIBs will experience an increase of 60 basis points, according to BPI projections. The U.S. already has very high capital requirements compared to other jurisdictions, and these further increases could constrain the banking sector’s ability to support U.S. economic growth.

  • What’s behind the increase? Part of this year’s increase in capital requirements stems from changes in the Fed’s scenario choices, such as a higher jump in the unemployment rate compared with last year’s scenario. Furthermore, the decrease in allowances for credit losses from the pandemic-era peak led to larger declines in capital ratios. But it is also clear that an abrupt increase in banks’ balance sheets during the pandemic – a flood of deposits – is causing the Fed’s models to overstate noninterest expense projections of large banks.
  • Potential solution: We urge the Federal Reserve to reevaluate the performance of its net revenue and operational risk models and adjust them so that each bank’s stress capital buffer reflects the risk profile of its business.
  • Crucial context: The Fed’s stress tests have evolved from a pass-fail model to a more dynamic regime that links stress test results directly to banks’ stress capital buffers. Results determine the SCB of each bank and thus its effective capital requirement. If a bank’s level of capital falls below its SCB, it faces restrictions on capital distributions.
  • The big picture: Very high capital requirements can harm banks’ ability to support the economy. This ability is particularly critical when there is a potential downturn on the horizon. U.S. capital requirements are already notably high compared to global counterparts.

Spotlight on Stress Tests

BPI Head of Research Francisco Covas, POLITICO reporter Victoria Guida and Eurasia Group special advisor Saul Martinez discussed the recent stress test results in a Twitter Spaces event this week. Here are key takeaways from the event.

  • Resilience: The stress test results showed a strong, resilient banking sector – a positive backdrop as the economy faces more challenging times ahead, Covas noted.
  • Biggest surprise: Several of the largest U.S. banks experienced large increases in their capital requirements (between 80 basis points and 1 percentage point). This was the biggest surprise of the stress test results, Covas said.
  • The reasons: One factor that explains the increase in capital requirements for some of the largest banks is the way the Fed’s models work, and the scale at which those banks supported the economy during the pandemic. As these banks took in a massive influx of deposits and invested them in safe assets, the Fed’s models assumed that their expenses and operational risk losses would go up. This assumption resulted in much higher capital requirements that didn’t match the actual risk level of the banks’ business.
  • Models, memory and momentum: The Fed’s models also exhibit a momentum effect where they carry over “memory” of recent performance into the next round of stress tests, Covas observed.
  • Macro context: Guida asked how higher capital requirements would interact with the Fed’s plan to raise rates to stem inflation. Covas noted the clear tradeoff between capital requirements increasing financial stability but also increasing the cost of lending, reducing demand for loans and affecting overall GDP.  More precisely, if the U.S. were to enter in a recession early next year, the increase in capital requirements would be procyclical and constrain economic growth.
  • The evolution: Covas and Martinez both discussed the evolution of the stress tests from a pass-fail exercise – with an element of public shaming – to a more mechanical link between the test results and banks’ capital requirements. The new framework is more efficient and simple, and it has changed the way banks make decisions on capital distributions. One thing that hasn’t changed is the degree of stringency, Covas said – this year’s test in particular has been one of the most stringent.

The Remarkable State of the CFPB

On June 28, a group of trade associations (which did not include BPI) sent a letter to the CFPB in response to its recently published examination manual. Statements in that manual reflect a significant reinterpretation of federal consumer law, and a significant expansion of its reach in substance and scope. The CFPB had not published the manual for public comment, though it appears to view it as legally binding. The letter raised substantive and procedural problems raised by the manual. Read BPI CEO Greg Baer’s perspective on the CFPB’s reaction here.

Wind-Down Safeguards Built for Global Banks Don’t Fit Large Domestic Regionals

After the global financial crisis, regulators imposed special new requirements on the largest global banks, or GSIBs, to make them easier to wind down safely if they failed. These requirements included total loss-absorbing capacity, or TLAC, and a single point of entry, or SPOE, resolution strategy. These requirements were designed specifically to address the unique challenges of a GSIB failure – namely, the complexity of resolving a firm with a big trading arm outside the insured bank subsidiary as well as materially significant operations in multiple foreign jurisdictions.  TLAC and SPOE provide very elegant and effective solutions to those challenges.

What’s happening: Certain policymakers are now recommending that these GSIB-specific resolution requirements (i.e., SPOE and TLAC) should be imposed on large regional banks. This recommendation is based on the false assumption that a failing large U.S. regional bank can only be resolved by selling it to a U.S. GSIB, when in reality there are many other options available, all of which are detailed in the resolution plans prepared by these regional banks – plans, it’s worth mentioning, that are subject to regular review and scrutiny by the Fed and FDIC.

The bottom line: Applying GSIB resolvability requirements to large regional banks doesn’t make sense because those firms, unlike GSIBs, don’t have big trading operations outside of their insured banks nor do they have material operations outside the U.S.  Moreover, imposing these ill-fitting requirements to large regional banks would impose substantial costs on them (and their borrowing customers) with no real tangible benefit.  It’s a solution in search of a problem, and would be a mistake.

To learn more, read BPI’s new post or access these links:

Financial Crime Fighters’ Huge Tech Revamp Is More Urgent Than Ever. Here’s What’s Needed to Finish It

To confront global threats like the anonymous shell companies enabling Russia’s war in Ukraine, Treasury’s FinCEN needs to implement the bipartisan Anti-Money Laundering Act of 2020, a long-overdue overhaul to the U.S. anti-money laundering framework.

  • The challenge: As a comprehensive update to the nation’s AML-CFT framework, the anti-money laundering overhaul is a heavy lift to implement. Tools to target financial threats have not evolved at the same rapid pace as the tools used by bad actors, who are exploiting sophisticated technologies like cryptocurrency to move illicit funds around the world. The new law gives FinCEN the modernized, targeted tools it needs to tackle global financial crime head-on, but it now needs experts to wield those tools to maximum effect.
  • Why it matters: The massive, tech-intensive overhaul, including the creation of a directory of companies’ beneficial owners, is crucial to empowering law enforcement, the U.S. government and banks to combat money laundering and other financial crimes.
  • Bottom line: FinCEN has a clear blueprint in front of it to fortify America’s anti-money laundering framework.  All it needs are more builders.

Toomey Raises Concerns on Kansas City Fed ‘Stonewalling’

Senate Banking Committee Ranking Member Pat Toomey (R-PA) and three other Republicans on the panel asserted that the Kansas City Fed was withholding information on its revocation of fintech Reserve Trust’s master account. “By continually stonewalling Congress, you have essentially asserted that the Kansas City Fed is not subject to any oversight by Congress or the public,” the senators wrote in a letter cited by Bloomberg. They called for an overhaul to the regional Fed banks to “make them more transparent and accountable to Congress.”

Usable Liquid Assets Would Unlock More Liquidity Under Stress

Liquidity buffers are only useful under stress if banks don’t feel compelled to maintain their regulatory minimums and are free to use their liquid assets. Several regulatory, supervisory and market factors currently discourage banks from doing so. Modifying these factors could enable banks to provide more economic support in stressful times.

What’s happening: The Bank Policy Institute this week commented on the Bank of England and Prudential Regulatory Authority’s discussion paper on the usability of liquid assets.

“Banks’ ability to utilize their stock of liquid assets to support the economy in times of stress is fundamental to the construct of the bank liquidity framework,” BPI SVP and Senior Associate General Counsel Brett Waxman wrote in the letter.

Context: The Bank of England paper examines the degree to which banks feel comfortable using their high-quality liquid assets, or HQLA, a pool of safe assets banks must hold to allow them to meet liquidity needs in a crisis. These assets are meant to be converted easily to cash during stressful episodes, but parts of the regulatory framework deter banks from utilizing them when their liquidity coverage ratio would fall below 100 percent, even when regulators say banks should use them.

Why it matters: An implication that liquidity buffers shouldn’t be breached hinders banks’ ability to support the economy when faced with liquidity stress. Banks need clarity from regulators on their expectations for using and maintaining high-quality liquid assets when appropriate and for those expectations to be understood and accepted by the market. The economy would benefit from regulatory and supervisory adjustments that clarify banks’ ability to use their liquid assets in times of stress.

To learn more, click here.

In Case You Missed It

The Crypto Ledger

Crypto hedge fund Three Arrows Capital defaulted on loans tied to large bets on tokens including the collapsed Luna, the Wall Street Journal reported this week. A British Virgin Islands court ordered the firm to liquidate after creditors sued it. Other crypto firms with exposure to the fund are facing potential losses, including lender and market maker Genesis Trading, whose losses could be in the hundreds of millions, according to CoinDesk.

  • Celsius risk: Crypto lender Celsius Network, which recently froze customer withdrawals, touted itself as less risky than a bank with better returns, but investor documents show it carried high risk, issuing large loans backed by minimal collateral, according to the Wall Street Journal.
  • North Korea: Crypto theft and hacking has become a source of foreign currency and a means of sanctions evasion to North Korea, according to the New York Times.
  • FTX eyeing Robinhood: Sam Bankman-Fried’s FTX is exploring an acquisition of Robinhood, according to Bloomberg.

BPI Urges Flexibility in Climate Risk Management and Acknowledgment of Data Gaps

BPI this week commented on the Financial Stability Board’s Interim Report on Supervisory and Regulatory Approaches to Climate-Related Risks. The final report should acknowledge the lack of supporting evidence and high costs of tools such as capital requirements for addressing climate-related risk, BPI wrote. It should also clarify that any supervisory approach to climate-related financial risk must recognize significant gaps in data, the early stage of modelling and methodologies and limits on climate data availability and quality. The final report should also enable financial institutions to be flexible in designing and implementing risk management approaches to climate-related financial risk.

U.S. Unveils New Russia Sanctions

The U.S. this week announced new sanctions targeting Russia’s defense industry and a ban on imports of Russian gold. The sanctions target entities and individuals including State Corporation Rostec.

MUFG Appoints New Executive Chairman for Americas

Mitsubishi UFJ Financial Group has promoted Masatoshi Komoriya to executive chairman of the Board of Directors for MUFG Americas Holdings Corp. and its U.S. banking subsidiary, the bank announced this week.

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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.