BPInsights: March 30, 2024

Long-Term Debt Proposal Has Higher Costs Than Advertised – and That’s Just the Beginning

The federal banking agencies have significantly underestimated the cost of their proposed long-term debt requirement. They also fail to account for a key source of higher funding costs: the need for regional banks to hold large buffers of long-term debt above the minimum amount to avoid tapping the market in times of stress.

Drastically higher costs: BPI’s analysis reflects realistic bank behavior in response to the proposed long-term debt requirement, such as the need to hold higher management buffers. According to this analysis, total bank funding costs for covered banks are projected to reach $6.6 billion, 4.5 times the proposal’s estimated costs of $1.6 billion. The assumption of higher management buffers accounts for an approximately 35 percent increase in the costs associated with the long-term debt proposal.

Breaking it down: Banks will need to maintain so-called “management buffers” – layers of long-term debt exceeding the required amount – to ensure they are not forced to issue new debt in stressed times with higher costs. This is a particular imperative for Category IV banks, the smaller subset of large regional banks covered by the long-term debt requirement. These smaller banks need to hold larger management buffers to operate smoothly during times of stress.

Bottom line: The costs of meeting new long-term debt requirements could increase significantly when factoring in banks’ need to hold large buffer amounts of debt above the minimum requirement. The banking agencies should consider that banks will need to hold large management buffers because of the uncertainty of funding costs and the need to avoid breaching regulatory minimums. The agencies should weigh the differences in the costs to comply with the new requirements among different types of banks, adjust the calibration and tailor those requirements appropriately.

Five Key Things

1. Credit Card Settlement with Merchants Shakes Up the Future of Interchange Fees, But Questions Remain

Large U.S. credit card issuers and networks, including banks, Visa and Mastercard, agreed to a settlement with merchants that would lower credit card interchange fees. The networks and banks will lower the fees that merchants pay to accept credit card payments and cap them for five years.  

  • Implications: The settlement also could enable merchants to charge customers more if they use certain premium rewards cards.
  • Last hurdle: The settlement marks a key milestone in years of litigation between retailers and credit card companies, but may not represent the final conclusion; the settlement requires approval from the U.S. District Court for the Eastern District of New York.
  • Elsewhere in interchange: The agreement comes as lawmakers have proposed legislation that would essentially impose price controls on credit card transactions. This legislation centers on the networks through which merchants route credit card transactions. While it purports to increase competition, it would actually reduce banks’ ability to fight fraud and offer rewards that customers value. In addition, the Federal Reserve is considering lowering the cap on debit card interchange fees under Regulation II, a move that would make it more costly for banks to offer products like free checking accounts.

2. New Paper Recommends Changes on Liquidity Rules, Discount Window, Capital

A new Brookings paper coauthored by former Federal Reserve officials Daniel Tarullo and Jeremy Stein and others offers recommendations on liquidity rule changes to address the bank runs during last spring’s failures. Strengthening liquidity regulation is preferable to expanding deposit insurance due to the risk of moral hazard associated with the latter, the authors suggest.

  • LCR changes: The liquidity coverage ratio should be modified to require banks to pre-position collateral at the Fed’s discount window to ensure they can cover a run, the authors recommend. They also suggest broadening the group of banks covered by the LCR: “Specifically, we propose a regulatory change that would require banks with more than $100 billion in assets to back their uninsured deposits by pre-positioning collateral—largely in the form of short-term government securities—at the Federal Reserve’s Discount Window.” The authors also recommended that loans pledged to the discount window could count as high-quality liquid assets, and that the LCR runoff rates for uninsured deposits be increased.

The paper also offered some observations on changes to capital requirements and to encourage mergers between regional banks.

  • Open to regional bank mergers: “Our analysis suggests that the business model of regional banks may be particularly vulnerable to the broad forces that are likely to shape the banking industry in the coming years,” the authors state. “Unlike the community banks, which focus on relationship lending to the smaller firms in the economy, regionals have lost a good chunk of their core business lending franchise to the non-bank sector. This leaves them disproportionately reliant on their deposit franchises for ongoing viability, at a time when the longer-run durability of these franchises also seems open to question.” Regional banks also may lack sufficient economies of scale and scope, they suggest. Therefore, “[m]ergers within the mid-sized regional sector might be one helpful mechanism in moving the process of consolidation along, while minimizing harmful medium-term effects on competition and financial stability.”
  • Interest rate risk: Regulators should rethink how the capital framework treats interest rate risk, such as that associated with Treasuries, the authors suggest. They express support for removing the AOCI filter for larger midsize banks, as in the Basel proposal. 
  • Crucial context: This paper comes amid forthcoming or pending proposals on capital, liquidity and M&A. On capital, policymakers are expecting broad and material changes to the Basel proposal after an influx of critical comments from all corners of the economy. On liquidity, the banking agencies are preparing to propose new measures, but it is not yet clear what form they will take, though they appear to favor an empowered role for the discount window. On M&A, regulators appear to be sealing up the pathway for deals and making reviews even more uncertain.

3. A Leaky Data Vault at a Government Vendor Raises Urgent Questions

A prominent instance of third-party data vendors for financial regulatory agencies misusing sensitive information raises concerns about how those agencies handle data and oversee their third-party contractors.

The case: The data vendor Argus recently reached a $37 million settlement with the Department of Justice, which accused Argus of a decade worth of improper use of data under contracts with financial regulators including the OCC, Federal Reserve and CFPB. Argus collected information on the regulators’ behalf and then misused it.  

Implications: The cases call into question federal financial regulators’ arrangements with third-party vendors and their risk management oversight of such relationships. These developments call into question federal financial regulators’ arrangements with third-party vendors that collect sensitive bank data on their behalf, and whether regulators are appropriately overseeing and managing the risks of such relationships.

JPMorgan Chase also filed a lawsuit against TransUnion, alleging that Argus, one of TransUnion’s subsidiaries, misused the bank’s credit card data while collecting it as a contracted vendor for financial regulatory agencies. 

4. Sarah Flowers Joins BPI Regulatory Affairs Team

Sarah Flowers, a leading regulatory attorney at U.S. Bank, will join the Bank Policy Institute as Senior Vice President, Senior Associate General Counsel. Sarah is expected to start on April 8.

At BPI, Sarah will be a senior member of the Regulatory Affairs team, focusing primarily on capital and stress testing, where she’ll work closely with BPI’s Head of Research, Francisco Covas. Sarah will also coordinate BPI’s Chief Financial Officers forum. She also is expected to work on a range of other prudential regulatory and related issues, including M&A. Sarah will succeed Katie Collard in the position.

“Sarah’s expertise in bank regulation, and capital and stress testing issues in particular, will bring a capable hand to the BPI team at a pivotal time for capital regulation,” said Executive Vice President and General Counsel John Court. “We’re delighted to bring her on board and believe she’ll strengthen our team immensely.”

5. BITS Responds to Treasury AI Report

The U.S. Department of the Treasury published a new report this week on the benefits and risks of the use of artificial intelligence in the financial services sector. The report responds to President Joe Biden’s Executive Order on the Safe, Secure, and Trustworthy Development and Use of Artificial Intelligence, issued in October 2023.

Chris Feeney, BPI Executive Vice President and President of BITS, issued the following statement in response: “We are encouraged by Treasury’s effort to proactively mitigate artificial intelligence risks and collaborate with industry to maintain a competitive and secure U.S. financial system. Today’s report acknowledges AI’s remarkable potential, the importance of ongoing public-private partnerships and the comprehensive regulatory regime already applied to banks. It also illustrates the industry’s existing ability to effectively manage technology risks and benefit customers through innovative new products and services.”

In Case You Missed It

The Crypto Ledger

Convicted FTX founder Sam Bankman-Fried was sentenced to 25 years in prison this week for fraud and conspiracy charges. Prosecutors had recommended a sentence of 40-50 years. The news marks a conclusion in the collapse of FTX.

  • SEC and Coinbase: The SEC succeeded in a key step in its suit against Coinbase, with a federal judge ruling this week that the case can move forward.
  • Russian crypto probe: The U.S. and U.K. are probing more than $20 billion of crypto transactions that passed through a Russia-based exchange, according to Bloomberg. The stablecoin Tether was used in the transactions. The probe is part of an international effort to crack down on Russian sanctions evasion amid the war in Ukraine.
  • The failure of FTX 2.0: Some creditors of the collapsed crypto exchange say its bankruptcy advisers missed the opportunity for a reboot, known as “FTX 2.0,” according to the Wall Street Journal.

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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.