BPInsights: June 10, 2023

Capital, Liquidity, M&A: Policy Recommendations After Recent Banking Stress

The Bank Policy Institute this week released a series of policy recommendations to strengthen the resilience of the banking system while allowing banks to continue funding economic growth. Collectively, they are a reasoned and holistic response to the failure of Silicon Valley Bank and troubles at other banks.

“In spite of recent events, the overall banking system remains strong and resilient. These recommendations are intended to offer informed, thoughtful insights to policymakers as they contemplate what additional actions could further strengthen the system,” said Jamie Dimon, Chairman of BPI, Chairman of the Board and CEO of JPMorgan Chase & Co.

“These recommendations will provide assistance in considering any changes made to the banking system, which is the bedrock of the American economy,” said René Jones, Vice Chair of BPI and Chairman and CEO of M&T Bank Corporation. “New policies should address the root cause of the recent events to ensure that banks of all sizes can continue being a vital source of lending to families, businesses, and communities across America.”

Said Greg Baer, BPI President and CEO, “Bank regulation is a complicated business, and comes with important costs and benefits. We have worked closely with our members to identify a series of policies that would target problems of interest rate and liquidity risk highlighted by Silicon Valley Bank and its fallout; we reject proposals by some that attempt to fit their favorite policy pegs into the unusually shaped hole that appeared in March.”

BPI is presenting two sets of recommendations: first, a small number of immediate steps that should be taken to avoid a significant reduction in bank lending; second, policy changes that would over the medium to long term improve bank resiliency and financial stability while minimizing costs to economic growth.

  • Read the full set of recommendations here.
  • Read BPI CEO Greg Baer’s Q&A with POLITICO here.

Recent Bank Failures Raised Questions. Higher Capital for All Banks is Not the Answer.

Some policymakers have pointed to recent bank failures to call for banks to hold even more capital. In particular, some have pressed to immediately put in place the most recent Basel changes to the capital framework, which will likely significantly raise the larger banks’ capital requirements. The banking agencies appear to be preparing to act on plans laid long ago to require banks to hold more capital, but using the recent idiosyncratic bank failures to justify it. This is wholly unjustified.

Lessons learned: There are clear takeaways from the spring 2023 turmoil. These include meaningful adjustments to the regulatory and supervisory framework. BPI this week released a set of over 20 policy recommendations intended to ensure the framework captures the risks that caused the recent failures, such as interest rate and liquidity risk management. But raising capital requirements on activities not related to those risks appears completely unwarranted. And the costs of such changes, such as reduced market liquidity and less lending to businesses and households, are considerable.

  • Failures of SVB, Signature and First Republic show that these banks should have managed interest rate and liquidity risk better or held more capital against these risks. But they do not show that all banks need additional capital. In terms of Basel, none of the three banks took meaningful market risk nor experienced material operational risk losses. Yet these are the key components of Basel overhauls, which some are depicting as a remedy for the problems behind the failures.
  • Increasing capital requirements across the board will unnecessarily impose costs on the overall economy. Higher capital is a blunt tool to decrease the likelihood of bank failures, and its benefits are reduced dramatically as requirements rise. The other side of the tradeoff is lower economic growth and a potentially more fragile financial system.
  • Implementing the international Basel capital standard in the United States will not address the interest rate and liquidity risks that underlay recent bank failuresAnd the forthcoming changes will likely disproportionately increase capital requirements for lending at a time when credit is already being crunched; and for market making at a time where illiquidity in capital markets could fuel financial instability. Using the recent stress of a completely different category of firms with entirely different risk profiles to increase capital requirements on larger banks is a non sequitur and risks distracting policymakers and stakeholders from devoting appropriate attention to changes that would in fact address the risks that were the undoing of the failed banks.

Five Key Things

1. The Change That Could Warp Capital for Some Large Banks

Banks reliant on fee-based revenue for custody activities, underwriting of securities, wealth management, credit card networks and other services could experience a significant increase to their capital requirements, as reported in a recent Wall Street Journal article. The upcoming U.S. proposal to implement Basel’s operational risk charge would disproportionately raise capital requirements for banks that whose revenues depend more heavily on fee-based services rather than interest on loans. This jump in required capital would overstate the actual risk of such activities. For some of the largest globally active banks, the overall increase in capital requirements from Basel implementation could be as high as 20 percent, according to the article.

  • What it is: Operational risk refers to the risk of losses from flawed or failed internal processes, people or systems or from external events such as cyberattacks.
  • Why it matters: Banks providing valuable services, such as underwriting debt and equity securities for U.S. businesses, doing custody of assets for their clients, managing clients’ funds, or providing credit card services, would face costs that are disproportionate to the risks of those services. This could make it more costly for those banks to serve their customers.
  • Key driver: The capital charge for operational risk is a major factor that is expected to contribute to a significant overall increase in capital requirements among large banks under Basel Finalization.
  • Open questions: As the U.S. Basel proposal emerges this summer, one important question is how the “internal loss multiplier” – an input that can amplify the operational risk charge – is set. An internal loss multiplier, or ILM, equal to 1 would limit the impact of previous operational-risk losses on a bank’s capital requirements. (This is the approach that the EU and UK have taken.) If the ILM is not set at 1, it would incorporate those past losses into the bank’s current capital requirements. Large operational risk losses are rare and are not good predictors of future losses, so it is inappropriate to link the current operational risk charge to previous losses.

To learn more about operational risk and capital, see these resources:

2. In SEC’s Crypto Crackdown, the Stakes Are High

The SEC this week sued crypto exchanges Coinbase and Binance over alleged violations of U.S. securities law, reflecting the agency’s intention to continue aggressively pursuing enforcement actions against crypto firms. The SEC accused Coinbase of operating an illegal crypto asset marketplace by failing to register with the agency. The regulator also alleged that Coinbase has engaged in an unregistered securities offering through its “staking as a service” program. The Coinbase charges appear more pedestrian and less expansive than the separate case against Binance, which Gensler said engaged in “an extensive web of deception, conflicts of interest, lack of disclosure, and calculated evasion of the law.” But both could be important tests of SEC Chair Gary Gensler’s crackdown on the crypto industry.

  • Unregistered: Gensler has repeatedly called for crypto firms to “come in and register” with the SEC. Both the complaints include allegations that the crypto firms failed to register their platforms or their products in the proper ways.
  • Global shell games: The SEC accused Binance of secretly allowing U.S. customers to trade on the Binance.com platform, contradicting the firm’s public claims that U.S. clients were restricted from using it. Founder Changpeng Zhao and Binance also stand accused of secretly controlling the Binance.US platform despite claims that it was a separate entity.
  • Mixed and mingled: Zhao and Binance also allegedly commingled and diverted customer assets, according to the SEC. This charge evokes the activities at failed crypto exchange FTX, whose founder will face trial in October.
  • Context: Binance faces a lawsuit from the CFTC and scrutiny from the Department of Justice over suspected money-laundering and sanctions violations.
  • Bottom line: The cases against both firms provide a view into the SEC’s quest to contain crypto’s bad actors. The Coinbase case may have important implications for the structure of crypto firms in the U.S.

3. Regulators Warn Banks to Address Third-Party Risks in Updated Guidance

The Federal Reserve, FDIC and OCC this week released new inter-agency guidance on how banking organizations should manage risks presented by third-party relationships. The guidance broadly addresses any business arrangements between a banking organization and another entity, by contract or otherwise.  These external partners could include IT service providers or technology firms such as data aggregators. The interagency release replaces prior guidance that the agencies each issued in recent years. It lays out a principles-based approach to risk management that covers all “stages” of a third-party relationship and sets expectations related to board and senior management oversight.

  • Risks and responsibilities: The agencies emphasized that third parties can introduce risks to a bank partner. Banks should apply particular scrutiny to third-party relationships centered on “critical activities” like those with major impacts on a bank’s financial condition. The guidance also instructs banks to perform an appropriate level of due diligence on third parties they work with, including vetting information security threats, and to review legal and compliance considerations around those partnerships.
  • Broad scope: The agencies considered comments in relation to excluding specific types of third-party relationships but decided not to exclude any specific third-party relationships from the scope of the guidance; rather, the guidance is relevant to managing all third-party relationships including inter-affiliate relationships.
  • Key context: The guidance comes as the OCC in particular has raised concerns relating to risks presented by certain bank-fintech partnerships, and agencies have brought enforcement actions against some banks ordering them to improve their oversight of bank-fintech partnerships.

4. What’s Next for the Treasury Market

Now that the debt ceiling has lifted, Treasury is going to issue a flood of securities, starting with bills. Treasury is on track to issue $450 billion of bills in the month of June alone, and will likely issue a total of more than $1 trillion over the four months from June to September, according to Lou Crandall of Wrightson ICAP. The funds are going to be used to finance the deficit and refill the Treasury’s account at the Fed, which is usually about $550 billion but got down to a historic low recently. (On the Friday before the debt limit bill was signed, the cash balance of the TGA was only $23.4 billion.)

  • The heavy issuance will likely push up bill rates a bit, pulling up other money market rates as well.
  • Some of the bills will be purchased by money funds, some of it will be purchased by bank depositors, and some by others.
  • With more bills in which to invest, money funds will invest less in overnight loans to the Fed at the ON RRP facility.
  • Bank deposit levels will come down as well, continuing the trend evident since the COVID crisis ended.
  • With the Treasury account at the Fed rising, reserve balances will fall, although that will be offset in part by the decline in the ON RRP.

It could be interesting on June 15 when new Treasury bills and coupon issues settle and it’s corporate tax day.  Reserve balances will fall, purchasers of those new coupons will need repo financing and money funds will be shifting toward those new bills.

5. What’s Missing in the CFPB’s $8 Late Fee Math

The calculations behind the CFPB’s proposed $8 limit on the credit card late fee safe harbor contain major gaps and errors. These errors paint a misleading picture of the significant costs associated with late payments.

What the proposal gets wrong: The Bureau’s proposal makes four key types of errors and omissions that may skew the ratio of late fees paid to the costs of late payments. These errors call into question the ability of an $8 limit to cover banks’ costs related to late payments.  

  • The data used by the Bureau excludes many of the costs associated with late or missed payments, including many costs related to credit card collections, resulting in an overstatement of the measured payment-to-cost ratio.
  • The Bureau’s exclusion of collection costs incurred after the loan is charged off is arbitrary and lacks economic justification.
  • The Bureau calculates the industry average fees-to-cost ratio weighting each individual bank’s ratio by number of accounts; this can make the calculation sensitive to outliers among individual banks.
  • The Bureau does not adequately consider the macroeconomic conditions during its selected period of analysis, which is not representative of a typical economic cycle. As a result, the measured fees-to-cost ratio appears to be higher than its long-run average.

To learn more, click here.

In Case You Missed It

The Crypto Ledger

A recent Reuters piece offers details on how Binance reached across borders to control bank accounts belonging to its supposedly independent U.S. affiliate. Executive Guangying Chen, a close associate of Binance CEO Changpeng Zhao, operated accounts at Silvergate Bank, including an account holding American customers’ funds. The investigative piece sheds light on how Binance allegedly breached the firewall separating it from its U.S. division – a significant part of the SEC complaint against the firm. A separate Bloomberg article reports that Binance and related entities shuttled billions of dollars through Silvergate and Signature Bank. Here’s what else is new in crypto.

  • Cut off: Binance.US will no longer process U.S. dollar transactions as it appears to be cut off from the U.S. banking system amid the SEC lawsuit.
  • States encircle Coinbase: State regulators, including in California and New Jersey, demanded this week that Coinbase halt its “staking” service. That service is a target of the SEC’s lawsuit against the company.
  • IRS victory: A federal court recently ruled that the IRS has the legal authority to access Coinbase users’ trading data via a “John Doe” summons.

Fintech Lending with Low Tech Pricing

Fintechs touting their potential to reinvent loan pricing are relying on the same traditional methods as other lenders, suggests a study by Brigham Young University’s Mark J. Johnson, Ohio State University’s Itzhak Ben-David and colleagues. Fintech lenders often suggest their methods can break out of traditional credit pricing models – and potentially broaden credit availability – by harnessing Big Data and machine learning. But this analysis reveals a persistent and significant dependence of fintech lenders on conventional credit scores for loan pricing. “In this paper, we show that loan pricing by FinTech lenders is far from utopic risk-based pricing,” the authors wrote. “FinTech lenders heavily rely on traditional credit scoring and do not incorporate other readily-available variable that are known to predict default into their pricing.” And ultimately, they wrote, “[o]ur results show that nonprime borrowers—especially those with low expected risk—cross-subsidize prime borrowers, especially those with high expected risk, leading to more expensive credit provisions for underserved populations.”

SWIFT Experiments with Banks Will Test Blockchain Interoperability

The SWIFT payment messaging network will collaborate with more than a dozen major financial institutions, including BNP Paribas, BNY Mellon and Citi, to test how they can leverage SWIFT infrastructure to transfer value over blockchain networks. Chainlink, a Web3 services platform, will provide connectivity across public and private blockchains for these experiments, according to a SWIFT press release.

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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.