BPInsights: March 2, 2024

10 Pitfalls to Avoid When Designing Any Additional Liquidity Requirements

The bank failures in spring 2023 have increased recognition of the importance of the discount window for liquidity risk management. The focus on discount window preparedness is a welcome development, but any new liquidity requirement should be developed thoughtfully and with input from all stakeholders. This note describes 10 pitfalls the banking agencies should seek to avoid when making changes to liquidity regulations. Those include:

  1. Be Clear on the Objective
  2. Do Not Repeat the Mistakes of the Past
  3. Please, No More Ratios
  4. Repos Provide Their Own Collateral if They Don’t Roll
  5. Reduce the Stigma Associated With Using the Discount Window
  6. Don’t Use Liquidity Requirements to Fix Other Problems
  7. Give Notice and Seek Comment Through an Advance Notice of Proposed Rulemaking
  8. Don’t Create an Inferior Rule Just So It Can Be Applied Uniformly to Institutions of All Sizes
  9. Make Conforming Changes to the Rest of the Liquidity Assessment Framework
  10. Eventually, Revisit the International Standard for the LCR

To read the full post, please click here.

Five Key Things

1. FDIC Revises Estimated Losses on Last Year’s Bank Failures

In its recently released 2023 Annual Report, the FDIC indicated it may have underestimated the losses associated with last spring’s bank failures by as much as 20%. The FDIC estimates that approximately $20.4 billion of that total is attributable to the cost of covering uninsured deposits as a result of the systemic risk determination (up from an estimate of $16.3 billion in November 2023). This significant revision could, in turn, increase the special assessment on large banks to recoup those losses.

  • Open questions: The reasons for the increased loss estimates are unclear. The FDIC emphasizes the actual losses remain uncertain and will continue to change “as assets are sold, liabilities are satisfied, and receivership expenses are incurred.” The FDIC plans to provide institutions with an updated estimate of their total special assessment amount in June 2024.
  • Breaking it down: The FDIC put Silicon Valley Bank and Signature Bank into receivership in spring 2023 after the banks failed. The FDIC invoked the “systemic risk exception” to cover the uninsured deposits at the two banks. The FDIC levied a special assessment on large banks in November 2023 to recover these costs, even while acknowledging their loss estimates—and institutions’ expected assessments—will continue to change.
  • In the backdrop: The FDIC Office of Inspector General recently issued a report on the FDIC’s top challenges, highlighting major staffing and employee attrition issues at the agency as a top concern. This echoes the concerns highlighted in the OIG’s material loss review related to Signature Bank and the FDIC’s own report on its supervision of Signature Bank. 

2. Breaking Down the Bank Merger Review Process

In contrast to the urban myth of “rubber stamp” approvals, the bank merger review process involves multiple federal agencies, rigorous standards and several complex legal steps. The reality is in most cases, bank mergers are approved because banks only apply to merge if they believe they already meet the rigorous standards for approval. Regulators warn banks not to apply if they have any reason to believe they will deny the application. If a bank applies anyway, the regulator may pressure them to withdraw before having to issue a public denial. Bank mergers are evaluated for anti-competitive effects, compliance with the Community Reinvestment Act and financial stability risk. Other factors include history of anti-money laundering issues and supervisory concerns.

To learn about how the process works, click here

3. The Climate of Uncertainty in Banks Predicting Physical Risk

Banks and regulators are increasingly looking at how climate physical risk could affect the financial system. Physical risk is the risk of financial loss driven by acute events, such as extreme hurricanes or floods, or chronic events, such as permanently elevated temperatures or sea levels.

The challenges: Physical risk has generated interest, but parsing it poses several challenges for banks trying to model it, creating uncertainty.

  • Physical risk is interdisciplinary, requiring results from physics, economics, hydrology, meteorology, fire science, industrial health, biometeorology and many other disciplines – areas unfamiliar to bank risk managers and regulators.
  • Climate science is not sufficiently advanced to make specific geographical predictions accurate enough for bank risk management.
  • Crucial outstanding questions in the academic literature in many areas must be resolved before physical risk management can become mature.

The right tool for the job: A new BPI post offers observations on these challenges and suggests that stress testing, as opposed to climate-adjusted risk modeling, is the right tool for bank risk managers to evaluate physical risk. Bank risk managers must understand what is known and what is unknown, and should design stress tests to probe the latter. Regulators should encourage the development of stress testing and should avoid physical risk expectations that require geographically imprecise metrics or the incorporation of physical risk into risk management models or parameters.

Case studies: The BPI post illustrates the difficulties in accurate physical risk analysis with two case studies. The first case study examines the effect of the increased frequency and severity of hurricanes on banks’ financial losses, showing that hurricane science is not sufficiently developed to make accurate geographical predictions. The second case study takes a deep dive into what is known and unknown about the problem of measuring the effect of higher future temperatures on bank exposures and local economies. In both cases, stress tests are the right risk management tool for the job.

Bottom line: Regulatory policy on climate risk should avoid getting ahead of the science by requiring banks to implement models and methods that are unusable given the current uncertainties. Such a premature approach could have real costs: If regulators require banks to disclose climate metrics that are highly uncertain, they could expose banks to significant legal risks.

4. Federal Preemption of State Law in Banking Faces Supreme Court Test

The U.S. Supreme Court this week heard oral arguments in a case centered on national bank preemption. The question at the heart of the case, Cantero v. Bank of America, is how to determine when federal banking law preempts state laws for national banks under the “significant interference” test established by Supreme Court precedent as well as the Dodd-Frank Act. The Cantero case arose from litigation accusing Bank of America of violating a New York state law requiring lenders to pay interest on borrower funds held in escrow accounts. A federal court of appeals ruled against the lawsuit, holding that federal law preempts the New York statute because it would exert “control” over the powers granted to national banks, and thus, “significantly interfere” with such powers.  In a different case, however, another appeals court held that a very similar California law was not preempted by federal banking law.  A U.S. Supreme Court decision in the Cantero case is expected to resolve the circuit split and serve as authoritative precedent on this question.  A decision is likely to be issued in June.

  • Skepticism: The plaintiffs’ approach to national bank preemption could lead to complex litigation around the country, Justice Samuel Alito said during oral arguments in the case this week. Several justices expressed doubts about the plaintiffs’ assertion that courts must examine the state law’s “practical effect” on national banks to determine the degree of burden posed by the law – a more fact-laden inquiry than traditionally applied by courts in preemption cases.  Justices Alito and Kagan were particularly concerned about the likelihood of inconsistent findings by different juries if the question is factual.
  • BPI’s view: BPI filed an amici brief in the case warning that this approach to preemption could result in state-by-state chaos and different conclusions as district judges around the country assess preemption based on a bank-by-bank and state-by-state analysis.  Bank of America argued that states would gain unheard-of powers to dictate aspects of how national banks run their business. A group of former OCC officials also filed a brief in support of Bank of America.

5. Bowman Raises Concerns on ‘Regulatory Tidal Wave’

Federal Reserve Governor Michelle Bowman expressed concerns in a recent speech to the Florida Bankers Association about the volume of regulatory proposals in the current pipeline. She reiterated the need, amid a “regulatory tidal wave,” for policymakers to ensure that changes lead to a framework that is tailored and properly calibrated. She also said “the vast number of finalized, proposed, and potential changes suggest a lack of prioritization.” Here are some key takeaways from her speech.

  • Capital: Bowman observed that a confluence of capital proposals – the Basel proposal, proposed long-term debt requirement and proposed revisions to the GSIB surcharge – “pose real challenges in striking the right balance between safety and soundness on the one hand, and efficiency and fairness on the other.” She noted the costs of higher capital requirements, such as higher prices for customers. On the next steps for Basel, she said: “My hope is that policymakers will take this opportunity to make significant revisions to the proposal to address the concerns raised by the public, and that I will be able to support the next step on Basel capital reforms.”
  • Interchange fees: Bowman expressed concern about the proposal to lower the cap on debit interchange fees under Regulation II. The proposal would have consequences for banks of all sizes, she said, and for customers such as low- and moderate-income families. “[W]ill banks be forced to discontinue their lowest margin products that target underserved populations, and what will the cost of such changes mean for financial inclusion?” she said. “How would this change impact the success of financial inclusion efforts encouraged by federal banking agencies, such as Bank On programs?”
  • Liquidity: As regulators consider whether to propose new liquidity requirements, “it is important to identify exactly what problem we are trying to solve,” Bowman said. Early efforts to draw conclusions from the spring 2023 bank failures – characterized by “hurried and incomplete analyses” prepared in their aftermath – “have generated many policy prescriptions, without fully diagnosing the problem,” Bowman said. She mentioned factors that policymakers must consider the limitations of liquidity regulation by itself, which does not improve supervision or risk management and can harm banks’ lending capacity. Liquidity regulation should be part of a broader consideration of regulatory tools.
  • M&A: Bowman said she remains concerned about the slow pace of merger approvals. Lengthy merger reviews can cause harm, such as employee attrition, she noted, and inefficient bank M&A processing can ultimately make the banking system less robust. “Taken together, reducing merger or acquisition activity could have the consequence of prohibiting transactions that may preserve the presence of banks in rural or underserved areas; transactions that may further prudent growth strategies or that may result in increased competition with larger peers,” she said.

In Case You Missed It

Ed Hill to Depart BPI; Erik Rust Promoted to Head of Government Affairs

Ed Hill will be departing the Bank Policy Institute as Head of Government Affairs, and Deputy Head of Government Affairs Erik Rust will be promoted to replace him. The changes will take effect March 22. Ed will join Forbes Tate, a multi-client advocacy firm.

“Ed Hill is one of a kind, and has brought both fine work and great spirit to BPI, so we are sorry to see him go; we’re excited, though, to elevate Erik to his new role,” said BPI President and CEO Greg Baer. “As a trusted advocate on Capitol Hill, Erik will advance BPI’s advocacy efforts through his deep policy knowledge on a range of issues important to our members.”

“We’re sad to see Ed leave, but we’re delighted to have Erik take the helm,” said Executive Vice President and Head of Public Affairs Kate Childress. “Erik’s banking policy expertise and fluency in the legislative process will enable him to serve our membership adeptly in this new role.”

Ed has led BPI’s government affairs team for three years following a long tenure as a government affairs executive at Bank of America. Erik, who joined BPI in 2020, has served for the last year as Deputy Head of Government Affairs, and his previous experience includes positions at the U.S. Chamber of Commerce and as a staffer in the House of Representatives.

Former Fed Governor: Basel Endgame Rule Could Undermine U.S. Financial Stability

Higher capital requirements under the Basel Endgame proposal could ultimately undermine the stability of the U.S. financial system, said former Federal Reserve Governor and University of Chicago economics professor Randall Kroszner in a recent American Banker op-ed. “As a result of the proposal, banks may reduce their activities or withdraw from providing critical products or services as they face nonbank competitors that are not subject to these regulations,” Kroszner wrote. “Critically, this shift to nonbanks could have the unintended consequence of diminishing the financial stability and economic resiliency and vitality of the U.S. for a number of reasons.” Nonbank firms, which lack banks’ stable deposit funding, may pull financing from borrowers in times of stress, he pointed out. Another source of instability is banks’ potential retreat from market-making, which would diminish liquidity and increase market volatility. Additionally, he noted, nonbanks are subject to much less disclosure and regulation than banks.

Stop the Stigma: BPI’s Nelson Discusses Discount Window, Liquidity on Macro Musings Podcast

BPI Chief Economist Bill Nelson joined the Mercatus Center’s Macro Musings podcast recently to discuss the Fed’s discount window, liquidity regulations and the Fed’s balance sheet. He emphasized the need to reduce discount window stigma, lessons learned in the wake of spring 2023 bank failures and why drowning banks in liquid assets isn’t the solution to bank run concerns. He offered a deep dive into the history of discount window stigma. He also discussed policy changes that could help the Fed get smaller. Listen to the episode here.

The Crypto Ledger

Here’s what’s new in crypto.

  • Oops: Some Coinbase users saw a zero balance displayed in their accounts as the app suffered from a glitch this week, CNBC reported.
  • SBF seeks shorter sentence: Sam Bankman-Fried’s lawyers are seeking no more than six-and-a-half years in prison for the convicted FTX founder, according to the New York Times.
  • Government witness: Accused crypto hacker Ilya Lichtenstein, now a cooperating witness in a U.S. money laundering case, revealed details of how he pulled off one of the largest bitcoin heists in history.

BITS Welcomes Launch of CRI Profile Version 2.0 

This week the Cyber Risk Institute announced the release of the CRI Profile Version 2.0. The latest update maintains alignment with the NIST Cybersecurity Framework 2.0 and introduces new features, including governance and supply chain risk management, to help the nation’s leading financial institutions comply with over 2,500 regulatory standards and practices.

Chris Feeney, BPI Executive Vice President and President of BITS, issued the following response:
“The CRI Profile remains an invaluable resource across the financial services industry since its launch in 2018, and we’re excited to support the ongoing success of the Cyber Risk Institute as it expands its capabilities and utility. Today’s announcement reflects the industry’s ongoing commitment to collaborating with regulators to prioritize compliance and safeguard the nation’s financial sector.”

Braunstein Joins Wells Fargo as Vice Chairman 

Former JPMorgan Chase executive Doug Braunstein has joined Wells Fargo as Vice Chairman, effective Feb. 28, the bank announced this week. Braunstein previously served in various senior roles at JPMorgan, including Chief Financial Officer, Vice Chairman, Head of Americas Investment Banking, Head of Global M&A, and Global Head of Industry Coverage.

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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.