BPInsights: July 22, 2023

SVB Deep Dive Stresses Supervisory Failure Over Tailoring

NYU Stern Business School released an extensive forensic analysis of the causes of the U.S. bank failures this spring and recommendations for related changes to supervision and regulation.  In addition to deeply flawed risk management on the part of the banks, the authors for the most part attributed the failure of supervisors to identify and require correction of the interest rate and funding risks of the banks.  They also point to the extended period of rapid Fed balance sheet growth and zero interest rates followed by extremely aggressive interest rate hikes in response to rising inflation. 

• What didn’t cause the failures: Two things the whitepaper concluded appeared to not have contributed to the failures were the 2019 tailoring of bank regulations or a newly lax supervisory culture, causes highlighted in the recent Barr report.  The authors note that SVB’s failure would not necessarily have been prevented if the bank had been subject to the liquidity, capital, stress testing, and resolution regime in place prior to the tailoring or applicable to larger banks.  “[T]his section concludes that the 2019 Tailoring does not seem to have weakened or eliminated any particular rule that would have averted SVB’s failure,” the authors wrote.
• Supervisory culture: The paper examines the differences between “preventive” supervision, “detective” supervision and “punitive” supervision and how they interacted in SVB oversight. Regarding the accusation that there was a lax supervisory culture that had been somehow instilled by Barr’s predecessor, the whitepaper observes: “It is not possible for an outside observer to assess these allegations because they are presented through aggregated accounts of anonymous interviews and because they are disputed by other accounts. For example, Federal Reserve officials at the time of the 2019 Tailoring claim that supervisors were urged to focus more on major, consequential issues and less on minor, technical infractions, and other former officials and observers claim that the Federal Reserve system’s culture of delaying action in an effort to gather extensive evidence and build consensus ‘has been endemic’ for years.”
• Three other things that did not cause the failures, in fact were not mentioned at all in the whitepaper, are operational, trading and credit risk, which are for some reason the focus of Vice Chair Barr’s imminent proposal to overhaul bank regulations.

Five Key Things

1. How Will Basel Affect Mortgages?

The U.S. banking regulators’ Basel proposal will likely include higher risk weights for home mortgages compared to the international standards, meaning they would play a more significant role in determining capital requirements, Bloomberg reported this week. Policymakers are considering applying risk weights of 40-90% for large banks’ residential mortgages, according to the piece. Loans with higher loan-to-value ratios are considered riskier and would face the higher risk weights. Currently, most mortgages on owner-occupied or rented properties that are not delinquent receive a 50% risk weight, regardless of the loan-to-value ratio. First-time homebuyers and lower-income borrowers tend to have higher loan-to-value ratios on their mortgages, so the increased risk weights could raise costs for these loans in particular.

• Bottom line: Overall, these proposed risk weights are 20 percentage points higher than those in the international Basel framework as the agencies wanted to go above and beyond the global standards, according to the Bloomberg article. Moreover, banks will have to include the operational risk charge add-on, which will result in an average increase of 15 percent in mortgage risk weights.
• Homeownership: The prospect of more expensive loans for lower-income borrowers has raised concern among housing advocates. “There may be no more effective way for regulators to undercut efforts to close the racial homeownership gap than by this capital proposal,” David Dworkin of the National Housing Conference said in a Capitol Account article.
• The implications: Higher capital requirements could make it more costly for banks to offer mortgages, top executives said on JPMorgan Chase’s recent earnings call. Part of the problem is the charge for operational risk, the risk of losing money in episodes like a lawsuit or cyberattack. “There are obviously more significant products that matter much more for the real economy like mortgage, where, you know, the layering on of the operational risk in the way it’s being proposed, especially if some of the other beneficial elements of the proposal don’t come through, you know, you’re once again making that product even harder to offer to homeowners,” CFO Jeremy Barnum said.
• Shadow banking: Nonbank lenders already dominate the mortgage lending market, with a 62% share of mortgage originations. Higher capital requirements for residential mortgages could exacerbate the shift outside the regulatory perimeter, which is ultimately bad for consumers. Nonbank mortgage lenders tend to be less willing to work with their customers when they are struggling to pay, and they do not face the same regulatory requirements, such as the Community Reinvestment Act, that banks do.

2. Bridging the Gap: How Mid-sized and Larger Banks Power Small Businesses

Mid-sized and larger banks play a crucial role providing credit to small local businesses. Unfortunately, they are particularly vulnerable to regulatory costs, as they have more substantial regulatory requirements than small banks and nonbank lenders but do not match the largest banks’ economies of scale. As policymakers weigh changes to regulatory tailoring after spring bank failures, they should keep in mind the consequences of cost pressures on small business lending.

• Growth engines: A new BPI analysis demonstrates the important role of mid-sized and larger banks in small business lending – a role that can’t be easily replicated. Mid-sized and larger banks originate more than half of small business loans in many of the 50 largest metro areas.
  • Small business loans from different size categories of banks tend to be regionally concentrated.
  • Mid-sized and larger banks’ small business lending tends to be more broadly distributed across counties than their deposits.
• Regulatory effects: In the wake of this spring’s bank failures, regulators are expected to reverse their tailoring of enhanced prudential standards for certain larger banks. Ultimately this increased (and misplaced) scrutiny will also affect many mid-sized banks as they grow. The imposition of excessively stringent capital and liquidity requirements for these banks will undeniably inhibit small business lending, given the considerably higher regulatory costs involved.

3. FDIC Special Assessment Proposal Lacks Analysis and Needs Adjustment to Avoid Unintended Side Effects

BPI responded this week to the FDIC’s proposed special assessment – the fee that the agency will levy on a subset of banks to recoup costs to the Deposit Insurance Fund resulting from the guarantee of uninsured depositors during bank failures this spring.

“The FDIC’s goal of simplicity across the board is understandable, but this proposal is flawed and could have undue effects on banks that the proposal fails to explain,” said Tabitha Edgens, BPI senior vice president and senior associate general counsel. “The FDIC should address these flaws in any future assessment, engage in deeper analysis of the factors underpinning this proposal and provide clear guidance to the public on how it would implement any similar assessments in the future.”

Flaws: The FDIC’s rationale contains several flaws. It lacks transparency, does not provide sufficient analysis to underpin its approach and may have outsize regulatory consequences for the affected banks.

Unintended consequences: The FDIC fails to in the proposal, but should in moving to finalize the rule, consider how the special assessment interacts with regulatory capital requirements, regular quarterly assessments, and other regulatory and accounting requirements to ensure the special assessment does not have an undue effect on assessed banks.

To read the full letter, click here.

4. Capital Changes, Slow Pipeline Chill Bank M&A Plans

U.S. banks will likely hesitate to pursue mergers and acquisitions until the end of next year as they anticipate changes to capital requirements, analysts observed in a Reuters piece this week. Long delays in deal approvals are also chilling M&A activity, according to the piece. “Instead of evaluating mergers based on competition and the needs of the community, political factors have become too important,” Meg Tahyar, head of the financial institutions group at Davis Polk, said in the piece. “There is also too much uncertainty about regulatory changes that will impact pricing.” After capital requirements are revised in the U.S., deals could surge for banks close to the $100 billion assets mark due to expected new capital rules applied at that threshold, the article suggested.

• Updated guidelines: Earlier this week, as anticipated, the DOJ and FTC issued draft updated merger guidelines for public comment. The proposed guidelines note that they are designed to help the public, business community, practitioners and courts understand the factors and frameworks the DOJ and FTC consider when investigating mergers.  Notably, the draft guidelines were silent on whether or not they would be intended to apply to bank M&A, which historically is subject to a separate industry-specific set of DOJ merger guidelines.

5. 10 Questions for the FedNow Launch

The Federal Reserve this week launched its real-time payments network, FedNow. The unveiling comes several years after the launch of a private-sector real-time payments service, the RTP Network – while some have implied that FedNow is filling a void in the market, instant payments have been readily available for six years. As a government alternative, FedNow faces different considerations than its private-sector counterpart, such as whether it is losing taxpayer money, how much transparency surrounds its budget and business plan and how the Fed will ensure it complies with statutory requirements to recoup all the costs it incurs in operating a payments system. The FedNow launch also raises questions of fairness – will the Treasury Department or banks be pressured to use the government-run system?

A new BPI post poses 10 questions for the new network’s launch.

1. How much taxpayer money has been spent to develop FedNow?
2. What is its business plan for the first five years?
3. Why hasn’t the Federal Reserve prioritized making its Fedwire Funds Service available 24/7? Will the Federal Reserve commit to action to make this a reality?

See the full list of questions here.

In Case You Missed It

Fees, M&A, Fintech: What’s on Rohit Chopra’s Mind

CFPB Director Rohit Chopra discussed his top policy priorities in several media interviews published this week. The interviews came as the CFPB faces a Supreme Court case on its funding structure, in which the high court will hear arguments on Oct. 3. Here are some key takeaways.

• Late fees: Chopra defended the CFPB’s analysis underpinning its late fee proposal in a Law360 interview, saying it was “far more rigorous” than the analysis the Federal Reserve put into the original safe harbor regulations. “We have been very clear that card issuers will still be able to charge penalty fees,” he said. “They just may need to show their math.” Chopra asserted in an American Banker interview that the law does not require regulators to give any “immunity provision” for credit card late fees. “It would be inaccurate to say that we have proposed a hard cap,” Chopra said. “What we proposed is to actually retain the immunity provision for which the card issuer does not have to demonstrate and show their math at all if they charge below that amount.”
• Other fees: As noted in the CFPB’s latest rulemaking agenda, the Bureau is considering writing new rules on nonsufficient funds fees and overdraft fees. “Perhaps to prevent recurrence and retrenchment, it will need either rulemaking or continued and concerted supervisory and enforcement efforts, or both,” Chopra told Law360. He expressed encouragement about many banks’ overhauls of their overdraft fees, and acknowledged that consumer demand has helped spur such changes.
• Fintech: In a POLITICO Pro Q&A, Chopra noted that “we have shifted a lot of our examination resources to those nonbanks, particularly those who reach a lot of consumers.” Chopra made the comment in response to a question about Basel capital changes pushing consumer lending into less regulated markets. “We certainly need to do much more to make sure we are mitigating or addressing any risks posed by systemically important nonbank institutions,” he said. He highlighted nonbank mortgage lenders – which now dominate the market — as a target of scrutiny. In the Law360 interview, he reiterated concerns about fintech account balances unprotected by deposit insurance.
• Competition: The CFPB is preparing to propose rules on open banking in October, Chopra reiterated in American Banker. The goal is to empower consumers to take control of their financial data, he said. “We really need a fair and competitive payment system,” he said. “Right now, for example, many banks cannot offer their own payment app that utilizes a mobile device’s near-field communication feature,” he said, referring to the “tap to pay” function.
• M&A: Chopra expressed support for even more stringent bank M&A standards. “We need to make sure that the process to adjudicate applications is far more rigorous and also transparent,” he said. He emphasized the financial stability factor in mergers of larger banks, in particular. On the acquisition of First Republic, he said: “Certainly, there have been questions posed about whether it’s appropriate to approve an acquisition by a bank that would otherwise be prohibited from purchasing it when there are other bidders who were interested.”
• Court case: Chopra said the Supreme Court case on the Bureau’s funding structure raises questions about the impact on the funding structure of other regulatory agencies, such as the Federal Reserve Board. He also flagged the FDIC, OCC and NCUA, “which also have a funding structure that, since roughly the Civil War, has not been subjected to the normal political football process of annual appropriations.”

SEC Declines to Weigh in on Kirschner Syndicated Loan Case

In the legal debate on whether syndicated loans should be considered loans or securities, the SEC’s opinion – which the Court of Appeals for the Second Circuit sought in the Kirschner v. JP Morgan Chase Bank case centering on that distinction — was highly anticipated. After making multiple requests to extend the deadline for filing a brief in the case, the agency ultimately decided not to opine.  “Despite diligent efforts to respond to the Court’s order and provide the Commission’s views, the staff is unfortunately not in a position to file a brief on behalf of the Commission in this matter,” SEC General Counsel Megan Barbero wrote in a letter on July 18.

• Why it matters: Syndicated loans — i.e., loans that a group of lenders, working in tandem, provide for a single borrower — are an important source of financing for institutions and businesses. Syndication makes loans less risky for the lender and less expensive for the borrower. Companies can also raise money in the corporate debt markets by issuing bonds. But Congress, courts and regulators have recognized these two avenues for funding as distinct from each other for decades. Upending that standard and treating syndicated loans as securities would raise costs for many institutional borrowers by subjecting them to SEC registration requirements. It would also vastly expand the SEC’s purview in credit markets overseen by the federal banking regulators.
• Context: In the Kirschner case, the Second Circuit is considering whether to overturn a decision by the U.S. District Court for the Southern District of New York holding that the syndicated bank loan in the case was not a security.  The Second Circuit had asked the SEC to weigh in.

Barr Warns of AI Fair Lending Risks

Federal Reserve Vice Chair for Supervision Michael Barr warned this week that new technologies such as artificial intelligence could violate fair lending laws. “While these technologies have enormous potential, they also carry risks of violating fair lending laws and perpetuating the very disparities that they have the potential to address,” Barr said in a speech this week at a fair housing event. “Use of machine learning or other artificial intelligence may perpetuate or even amplify bias or inaccuracies inherent in the data used to train the system or make incorrect predictions if that data set is incomplete or nonrepresentative.” Barr said bank supervisors are monitoring potential fair lending violations based on technology, such as AI, opaque models and marketing that may exclude certain groups. He also noted, without providing timing details, that the banking agencies are working on a final rule revising the Community Reinvestment Act regulations.

BPI’s Greg Hopper Discusses Bank Failures on NBER Panel

BPI Senior Fellow Greg Hopper participated recently in a panel on the spring bank failures at the National Bureau of Economic Research Summer Institute. Other participants included Doug Diamond of the University of Chicago’s Booth School of Business, former Boston Fed President Eric Rosengren and Til Schuermann of Oliver Wyman. The discussion covered the failure of SVB supervision, stress tests and accounting. Regulators have a strong bias toward an auditor mindset – focusing on process issues and governance, Hopper said at the panel. There were plenty of MRAs and MRIAs against SVB, but not on the bank’s most crucial issues, he noted. Hopper also highlighted how subjectivity is a strength and a weakness of stress tests.

Watch the discussion here (Hopper’s panel begins at 2:25).

Climate Financial Risk at Forefront of House Panel Hearing

Climate risk in bank regulation was the subject of discussion at a hearing by the House Financial Services Committee Subcommittee on Financial Institutions and Monetary Policy this week. Republican lawmakers criticized the notion of climate-related financial risk as subjective and prone to gaps and uncertainty in modeling. Regulators should not assume they know more than the private sector, which is closely monitoring these emerging risks, Subcommittee Chair Andy Barr (R-KY) said at the hearing. “Regulators are saying that their efforts are intended to help banks manage risks that are not yet fully understood, even by the regulators, with the underlying premise that somehow, the prudential regulators know better than the private sector,” Barr said. “That seems odd, given that the Fed says that they must exercise humility about spotting risks and they couldn’t even help institutions manage interest rate risks,” he added, referring to the Fed’s supervision of SVB. Democratic lawmakers warned of a “politically driven underreaction” to climate change.

• Business decisions: Senior OCC official Greg Coleman emphasized that the regulator is not micromanaging banks’ client decisions. “The OCC does not and will not tell bankers what customers or legal businesses they may or may not bank,” Coleman said. “Rather, we are committed to staying focused on banks’ risk management of climate-related financial risks.” Federal Reserve Board official Michael Gibson, the director of the Division of Supervision and Regulation, expressed a similar sentiment in response to a question. “It’s not the Federal Reserve’s policy to discourage a banking organization from offering accounts or services to any class or type of law-abiding business,” he said.
• Pilot climate scenario analysis: Gibson noted that the Fed is conducting a pilot climate scenario analysis exercise involving six large banks, exploring how they would handle various climate scenarios. The exercise is distinct from supervisory stress tests that determine capital requirements, he noted.

Joint Trades Support Advancement of FISMA

BPI, the American Bankers Association and the Securities Industry and Financial Markets Association issued the following statement in response to the bicameral, bipartisan Federal Information Security Modernization Act of 2023 (FISMA), which would improve information security practices at federal agencies:
“Federal agencies should be held to the same standards as private companies when it comes to protecting sensitive consumer data and reporting cybersecurity incidents. FISMA will improve accountability among federal agencies and give financial institutions the critical information they need to protect their customers following a cyber threat.”
The legislation introduced last week (S. 2251 and H.R. 4552) includes two key provisions that would enhance transparency over federal agency information security practices. It would:

1. Require federal agencies to notify private sector entities whose sensitive information is compromised during an agency cybersecurity incident; and
2. Help inform financial institutions of any long-standing federal agency security shortcomings and the effect of those weaknesses by making the information accessible via an inspector general dashboard.

The Crypto Ledger

The Financial Stability Board this week issued its Final High-Level Recommendations for the Regulation, Supervision and Oversight of Crypto-Asset Activities and Markets and similar recommendations for global stablecoin arrangements. The FSB has stated these recommendations are grounded in the principle of “same activity, same regulation.” Final recommendations on regulation of crypto asset service providers were revised from an earlier iteration to address the events of the “crypto winter” – for example, recommended restrictions on related-party transactions, such as those between FTX and its affiliate. Here’s what else is new in crypto.

• Mashinsky’s fall from grace: Celsius founder Alex Mashinsky promised his customers high returns with the safety of a bank, but now faces charges that he deceived and defrauded those clients. A recent Bloomberg piece lays out a long trail of alleged deceptions that belie the disgraced founder’s underdog image.
• Ripple: SEC Chair Gary Gensler said the agency is “disappointed” with part of a recent court ruling on Ripple tokens regarding retail investors, but “we’re still looking at it and assessing that opinion.” The SEC scored a partial victory as the court ruled that institutional sales of the tokens violated securities laws.

Comerica Highlights Support for Small Business, Communities

Comerica recently released its latest Corporate Responsibility Report, which highlighted its support for small business capital access, low- and moderate-income individuals and community development, among other initiatives. The report also outlines Comerica’s sustainability efforts, professional development programs and employee benefits and customer experience..