BPInsights: June 3, 2023

2 Different Capital Requirements, Same Risk

Risk-based capital requirements are designed to account for specific risks on a bank’s balance sheet. For example, “market risk” capital requirements correspond to the risk of losses in a bank’s trading operations. As part of an update to the Basel capital framework, a global set of regulatory standards, policymakers will soon introduce a measure called the Fundamental Review of the Trading Book to encapsulate market risk. But another measure, the Global Market Shock in the Federal Reserve’s stress tests, already captures this same risk. What does that overlap mean? Implementing one market risk requirement without redesigning the other would significantly increase capital requirements – not by capturing new risk but by increasing capital charges for the same risk.

  • Venn diagram: new BPI note breaks down how the FRTB captures the same risks as the GMS for a simple example portfolio. (This note is the second in a pair of posts. The previous post here discussed the five risk management problems with value at risk and why the FRTB’s “expected shortfall” measure is designed the way it is.)
  • Grounds for caution: Large rises in market risk capital requirements without an actual increase in banks’ risk could damage market liquidity. At some point, increases in market risk capital do not make the financial system safer, but instead reduce liquidity, which then necessitates even more capital to account for the loss of liquidity. New market risk capital requirements could make the liquidity risks that the FRTB was designed to measure a self-fulfilling prophecy.
  • Redesign: There are several options to update the GMS, each with its own set of tradeoffs. The redesign would likely need to be done in stages. The process could start by changing some pieces to keep market risk capital relatively constant once the FRTB is implemented. The second step in updating the GMS would be stressing different risks than the FRTB.
  • Bottom line: The GMS needs to be updated to cover different risks if it is to complement rather than duplicate the FRTB. Any revamped GMS should not raise market risk capital unless there is a clear increase in underlying risks. Given the complexity of the potential options and the significant effects on U.S. financial markets, ample room for public input is necessary.

Five Key Things

1. Coming Soon to a Capital Framework Near You: Basel, Stress Test Changes

Federal Reserve Governor Philip Jefferson flagged the upcoming U.S. Basel Finalization proposal currently in the works at the banking agencies in a speech this week. “At the same time, the Federal Reserve staff is considering ways to enhance the ability of stress tests to capture a wider range of risks and identify vulnerabilities at the largest banking organizations,” Jefferson said.

  • Key quote: “The revised framework should improve the resilience of the banking system by producing more robust and internationally consistent capital requirements for large firms, building on improvements made to the capital framework following the Global Financial Crisis. Importantly, the revised framework is expected to reduce unwarranted variability in capital requirements. By increasing standardization, these reforms aim to increase transparency and public confidence in risk-weighted assets while also reducing complexity.”
  • Context: Vice Chair for Supervision Michael Barr recently noted that he expects the Basel proposal to come “this summer.” Any changes to capital requirements will have meaningful effects on banks’ ability to finance the economy.

2. BIS Chief Calls for Supervision to ‘Up Its Game’

Bank for International Settlements head Agustin Carstens called for focused, effective bank supervision in the wake of recent bank failures in a speech this week. “Banking supervision needs to up its game. It needs to identify weaknesses at an early stage and act forcefully to ensure that banks address them,” Carstens said. “To do this, supervisors will need to have operational independence, strengthen their forward-looking culture and adopt a more intrusive stance.” He also placed blame with bank management for the recent collapses. “The ultimate cause of recent bank failures lies with the institutions themselves, not with regulators or higher interest rates,” Carstens said. “There is no excuse for institutions to mismanage interest rate risk, or to fail to address long-term structural weaknesses in their business models.”

  • Supervision: Carstens said many issues among the failed banks could “and in my view should, have been identified and remedied ahead of time.” He called for supervisors to improve their effectiveness by investing in more resources and increase the use of technology for more productivity gains. He noted that some of the failed banks “had a long track-record of financial underperformance,” and that “the weaknesses of their business models had been clear for some time.” Others experienced financial challenges suddenly as interest rates rose and the value of their long-term, fixed-rate assets declined, he said.  Ultimately, “there is simply no reasonable level of minimum capital and liquidity that can make a bank viable if it has an unsustainable business model or poor governance,” he said, making supervision important.

3. How Long Do Deposits ‘Stick’? The Math Behind That Question Could Change

SVB’s failure raised important questions about how “sticky” bank deposits are in a rising-rate environment. The willingness of depositors to stick with the same bank amid rising rates – in other words, the “price sensitivity” of depositors – is a crucial variable in banks’ assumptions about their balance sheets. Although deposits are redeemable on demand, economic models tend to assume they will stick around long-term because of the value of other services a bank provides. But models may need to consider factors like rapid Fed rate increases, the speed of digital banking and the share of run-prone deposits in the system, according to a recent POLITICO article.

  • What the research says: Analysis from Goldman Sachs and the New York Fed suggest those assumptions may warrant a rethink. Changes such as digital banking speeding up withdrawals and an underestimated share of run-prone deposits could make unrealized losses on banks’ securities a more urgent issue. These losses arose when the Fed raised interest rates rapidly and the value of long-term securities declined in response. Holding more fixed-rate assets results in greater interest rate sensitivity, but the decline in fixed rate asset values amid rising rates is offset by the increasing value of deposit funding, according to the New York Fed analysis. Another analysis by NYU’s Alexi Savov and Philipp Schnabl and Wharton’s Itamar Drechsler also examines the subject. The authors calculate that in the extreme case that all deposits run, banks would be exposed to their entire loss on securities and loans, which they estimate is $1.75 trillion, which is large relative to banks’ equity capital of $2.2 trillion.
  • Worst-case scenario: The New York Fed post explores what happens if depositors withdraw their money regardless of the rate the bank pays. “In this scenario, the bank may not be able to hold its assets to maturity, and the market value of the assets becomes immediately more relevant in assessing the bank’s financial position.”
  • Liquidity stockpile: Long-term securities – part of the stockpile of safe liquid assets that banks hold to meet regulatory requirements – have offered a low-risk stream of income when benchmark interest rates remained low.
  • Next steps: If banks sell longer-term assets to offset less-sticky deposits, that could mean a significant shift in banks’ business models, which have traditionally been “lend long, borrow short”.  

4. CFPB: Beware of Unprotected Funds on Nonbank Payment Apps

The CFPB this week warned in an “issue spotlight” that funds stored in nonbank digital payment apps, such as Venmo, PayPal and Cash App, may not be safe in a crisis because they may not be covered by federal deposit insurance. These payment apps lack the same protections that banks have to ensure funds are safe, the CFPB said. “As tech companies expand into banking and payments, the CFPB is sharpening its focus on those that sidestep the safeguards that local banks and credit unions have long adhered to,” Director Rohit Chopra said in a press release.

  • Key context: The Bureau drew a contrast between banks and payment apps by pointing out that even in acute crises like the recent bank failures, customers benefited from deposit insurance protections.
  • In the courts: Separately, PayPal and the CFPB have been embroiled in a legal battle over whether providers of digital wallets are required under the CFPB’s prepaid card rule to disclose certain fees.

5. Deep Dive Into New OCC Enforcement Action Policy Applying to Banks with “Persistent Weaknesses”

The OCC late last week announced updates to its policies and procedures manual on enforcement actions, aimed particularly at any large banks determined by the OCC to have “persistent weaknesses” – i.e., generally, those that have longstanding risk-management-related supervisory concerns. The update formalizes certain aspects of Acting Comptroller Michael Hsu’s January remarks on what he referred to as “too big to manage” banks. The policy is set out in a new “Appendix C” to the OCC’s enforcement action policies and procedures manual.

  • Key quote: “[T]his revised policy promotes strong management by making clear that a bank’s inability to correct persistent weaknesses will result in proportionate, fair, and appropriate consequences, including growth restrictions and divestitures when warranted … These guardrails are especially important today, as banks grow to better serve their communities, improve their competitiveness, and achieve economies of scale. Well-managed banks provide invaluable support to our economy, and this revised policy promotes this result.”
  • What are “persistent weaknesses”? The OCC introduces a new term – “persistent weaknesses” – to the bank regulatory lexicon. This label triggers the presumption that the OCC will employ a framework of escalating responses via enforcement actions.
  • Rule of threes? The OCC leaves the door open for use of discretion in identifying banks with “persistent weaknesses”, but suggests that it likely includes CAMELS management ratings of 3 or worse, three or more weak or insufficient-quality risk management assessments for more than three years or multiple enforcement actions against the bank executed or outstanding during a three-year period.
  • Bottom line: The new enforcement policy formalizes an escalating enforcement path that could include the OCC requiring institutions to raise capital or dedicate additional resources to risk management and end in forced divestment of business lines, and reflects Hsu’s concern that some large, complex banks are not resolving supervisory issues quickly enough. It suggests a presumption for further enforcement actions if a bank with less-than-satisfactory ratings does not resolve them within three years. At the same time, the new policy does not bind the OCC to take particular actions.

In Case You Missed It

LIBOR Is Dying. How Are Businesses Preparing?

LIBOR’s presence in the global financial markets will soon draw (mostly) to a close at the end of June. A recent Wall Street Journal article discusses how U.S. companies, such as those issuing corporate debt, are preparing for that date.

  • Halfway there? About 55 percent of U.S. loans in collateralized loan obligations were tied to LIBOR as of May 30, with the remaining 44 percent tied to SOFR, an important alternative rate. While that percentage is notable, it’s down significantly from 79 percent at the end of last year.
  • IT update: A key part of LIBOR turnover is firms updating their information technology systems to incorporate new rates.
  • Disruption unlikely: Firms with LIBOR-tied loans could face operational risk or higher borrowing costs if they leave them unaddressed. But broad market disruption is unlikely even if some loans remain ostensibly linked to LIBOR, partly because many firms’ loans automatically switch to SOFR after the phaseout, according to the article. (For tough-legacy contracts with no adequate fallback language facilitating the switch to another rate, Congress passed bipartisan legislation to smooth the transition.)
  • Synthetic LIBOR: Some corporate borrowers may transition to use a “synthetic” version of U.S. LIBOR for 15 months through Sept. 30, 2024. These LIBOR rates are not meant to be representative of the underlying lending markets.

The Crypto Ledger

Here’s the latest in crypto this week.

  • Insider trading case settled: Former Coinbase manager Ishan Wahi reached a settlement with the SEC in a noteworthy crypto insider trading case. The settlement left unresolved a key question for the SEC, according to a Wall Street Journal article: which of Coinbase’s digital assets are securities. Wahi was recently sentenced to two years in prison in a related criminal case.
  • Laundering the loot: A hacker who took over the sanctioned crypto mixer Tornado Cash used the obfuscation tool to launder the tokens he or she plundered during the attack, according to Bloomberg.
  • CFTC warning: A unit of the CFTC this week warned clearing agencies providing services for crypto products that they must contain risks associated with those assets, according to Law360.

BofA’s Breakthrough Lab Boosts Entrepreneurs from Underrepresented Communities

Bank of America recently launched a program called Breakthrough Lab that provides tailored mentorship, digital expertise, networking opportunities, investor connections and other support to entrepreneurs from underrepresented communities. The initiative aims to promote financial inclusion with the goal of supporting small businesses.

Next Post: BPInsights: Jul 13, 2024 View Next Post


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.