Where Shadow Banks Fit in the Capital Equation
The growth of the U.S. economy depends on banks’ ability to finance businesses and provide credit to households. However, high capital requirements result in costs that impede this capacity. While capital requirements have benefits, such as lowering the likelihood of bank failure, it is crucial to balance the tradeoffs to avoid sacrificing U.S. economic vitality.
Stability tradeoff: Policymakers must consider the full backdrop of how Americans finance their credit needs when balancing these tradeoffs: Shadow banks, which increasingly offer loans to households like home mortgages, have gained market share at the expense of traditional banks due to regulation. Higher capital requirements may discourage banks from offering more loans, causing shadow banks’ presence in the market to grow and the financial system to become less stable. During stressful times, shadow banks also pull back lending much more than banks, exacerbating market and economic turmoil.
The optimal level of capital: A recent academic paper by Begenau and Landvoigt (2022) attempts to quantify the costs and benefits of tighter capital regulation and suggests the optimal capital requirement for U.S. banks would be 16 percent, a 2-percentage-point increase from the current Tier 1 capital ratio. However, the paper gets several important things wrong.
- Nonbank financing casts a longer shadow: The world envisioned in the paper is one where both banks and nonbanks provide financial intermediation, but it underestimates the role of the shadow banking sector in providing credit to American businesses and households. The paper’s narrow definition of the shadow banking sector fails to capture its significant presence in markets like home mortgages.
- Paper ignores post-crisis reforms: The paper assumes that banks hold only risky assets and that all bank liabilities are insured. However, in reality, banks are required to maintain a significant portion of high-quality liquid assets and a significant amount of long-term debt that can be converted to equity in the event of a bank’s failure. These reforms have been implemented to reduce the potential magnitude of a bank’s losses during a crisis and the likelihood of the bank’s failure, thereby reducing the optimal capital that banks need to hold.
Bottom line: When considering the optimal capital level for U.S. banks, the context of an economy increasingly financed by less regulated shadow banks should be considered.
Five Key Things
1. House Republicans to CFPB: Late Fee Cap Would Raise Costs for Everyone
The CFPB’s proposed $8 credit card late fee cap would lead to higher costs for all credit card customers, including those who pay on time, a group of GOP lawmakers on the House Financial Services Committee wrote in a letter this week to Director Rohit Chopra. The proposal could remove incentives to pay on time, making it more likely for people to pay late. “That, of course, means more shifting of delinquent payment costs to other, innocent, consumers who absorb the associated costs through higher rates or inability to further access unsecured credit that they may need to smooth their consumption,” the lawmakers said in the letter. The need to cover the costs associated with late payments could also chip away at credit card rewards that consumers value, they suggested.
- No adjustment: The lawmakers also expressed concern that the CFPB did not include credit card late fees in December 2022 when it issued annual fee adjustments as required by Regulation Z. These regular adjustments reflect changes to fee safe harbors due to inflation. “Picking and choosing whether to make adjustments to reflect inflation among the various provisions of Regulation Z amounts to selective indexation which, in turn, is junk economics,” the letter said.
2. Russian Oligarchs Hide Money in the U.S. – Only Reliable Data Can Stop Them.
The U.S. is one of the easiest places in the world to set up an anonymous shell company. The Anti-Money Laundering Act aimed to change that with steps including the Treasury Department’s new business owner database. But the effort to fight illicit finance that enriches and enables Russian oligarchs, terrorists and human traffickers won’t succeed unless all parties involved – law enforcement, U.S. regulators and banks – trust and use the new systems under development, BPI’s Greg Baer and Transparency International’s Gary Kalman wrote in a new American Banker op-ed. FinCEN must verify the beneficial ownership data in the directory so that its users can rely on that information. This step would streamline investigations and the screening that banks undertake before granting someone access to the U.S. financial system.
3. Unleash the Banks in Times of Crisis
In a recent Wall Street Journal op-ed, former Treasury official Justin Muzinich and former Fed Vice Chair for Supervision Randal Quarles called for policymakers to empower banks to step in as “shock absorbers” in times of market stress. Large U.S. businesses rely on a mix of bank credit, corporate debt and short-term wholesale funding like commercial paper for funding. Short-term wholesale funding can be vulnerable to sudden shocks, and banks, not the government, should step in to provide liquidity under stress, Muzinich and Quarles wrote. But “overcalibrated capital and liquidity requirements … have limited the ability of banks to step in when the nonbank system falters,” they wrote. “By adjusting some of those requirements during times of crisis, we can encourage a more fluid transfer of funds between banks and the market.” They called for a new law allowing the Fed to suspend leverage capital requirements for a limited period of time during a crisis, to be reinstated afterward.
4. BPI Welcomes Thoughtful Approach to Modernizing Financial Privacy Legislation
In the decades since the Gramm-Leach-Bliley Act established federal privacy standards for financial institutions, many banking services evolved from dial-up and strictly brick-and-mortar to handheld, digital and instantaneous. It makes sense to consider modernizing the framework to fit the expectations and practices of modern finance. New legislation from House Financial Services Committee Chairman Patrick McHenry (R-NC), the Financial Data Privacy Act, takes a thoughtful approach to this process, BPI said in a recent letter submitted for the record.
Context: Congress enacted the Gramm-Leach Bliley Act in 1999. While the technology of banking has transformed since then, the stringent safeguards have been consistent through the decades – banks have consistently faced the strongest privacy requirements in the country. The bill, which the House Financial Services Committee advanced this week, would modernize that landmark law by imposing new federal protections for customers regardless of where they live in the U.S.
What BPI is saying: “This legislation would promote seamless access to financial services by ensuring that customers have the same privacy protections consistently across the country. The process of revamping privacy law for banks deserves careful consideration, and this bill is a step in the right direction for bank customers.” – Greg Baer, BPI President and CEO
To learn more, including BPI’s recommendations for the bill, click here.
5. The Real Costs of Bank Capital: Key Takeaways from BPI’s Symposium
BPI this week held a symposium on the costs and benefits of bank capital. Participants included JPMorgan Chase CFO Jeremy Barnum, Credit Suisse Managing Director and bank analyst Susan Katzke and Brookings Institution Robert V. Roosa Chair in International Economics and Senior Fellow Donald Kohn, a former Vice Chair of the Federal Reserve. BPI CEO Greg Baer moderated the discussion. Here are some takeaways from the event.
- The costs of capital: Policymakers face critical decisions as they prepare to propose rules implementing Basel Finalization in the U.S. Even small adjustments to these rules can have large ripple effects. “If those choices produce net overall increases on the capital requirements in the banking sector, there are going to be real consequences to the availability of credit for firms and individuals as well as on market liquidity,” Barnum said. “Importantly, even if those changes … may seem small or technical, they can have outsized consequences.” Some requirements, such as the supplementary leverage ratio, have harmed capital markets liquidity. Kohn has urged the Federal Reserve to take action on the SLR, which it had promised to do “soon” two years ago.
- Decisions: “Capital requirements are a key input into our day-to-day decisions about lending and many other activities that we perform that are important to the real economy,” Barnum said. He described how the bank navigates business decisions based on the cost of capital – for example, on mortgages or corporate lending. “In response to higher capital requirements, banks have two choices. We can charge higher prices or we can do less lending. Both of those choices are ultimately bad for consumers and businesses,” Barnum said. One potential unintended consequence of higher capital requirements is the migration of financing activity into the shadow banking sector, he said. In the U.S., oversight of the nonbank sector is fragmented among multiple regulators, some at the state level, with no comprehensive systemwide view of stability, Kohn said. The Fed should consider the costs and benefits capital and that the cost includes the allocation of credit outside of the banking system, he said.
- The shape of buffers: Panelists also discussed the implications of capital buffers, which suffer from a “usability” problem – banks are generally hesitant to use them, so they essentially act as an extra capital requirement. A bank dipping into its buffer strikes an alarming signal for investors, Katzke noted. Kohn expressed support for a countercyclical capital buffer – one that can be turned on or off depending on the state of the economic cycle, requiring banks to hold more capital when times are good and “releasing” the buffer during stress — which the U.K. has used but the U.S. has not.
In Case You Missed It
The Crypto Ledger
Silvergate Bank is examining its viability as a business, a culmination of turmoil after FTX’s collapse roiled the crypto-specialist institution late last year. The bank is reviewing its financial controls and disclosed that it could not file its annual report on time. Silvergate sold additional debt securities in January and February and said losses related to its securities portfolio, along with other factors, could impair its ability to operate as a going concern, according to Bloomberg. The bank confirmed it was being investigated by the U.S. Department of Justice. Here’s what else is new in crypto.
- CBDC huddle: The Treasury Department is leading an interagency working group on central bank digital currency, senior official Nellie Liang said in a speech this week. In the coming months, officials from Treasury, the Federal Reserve and several White House offices will begin regular meetings to discuss a potential CBDC “and other payments innovations,” Liang said. The working group, which Treasury’s Report on the Future of Money and Payments called to establish, is developing an initial set of findings and recommendations. The group will aim to complement the Fed’s work on a potential CBDC and will consider CBDC implications for policy objectives such as global financial leadership, national security, privacy, illicit finance and inclusion.
- Meanwhile, in the U.K.: A digital British pound could help protect consumers from bank runs, Bank of England Deputy Governor Jon Cunliffe said recently, according to Bloomberg. Cunliffe touted what he views as the financial stability benefits of CBDC. But his remarks, while largely positive, appeared to acknowledge some risks. “While allowing them to move their money even faster than currently possible and into a CBDC could present ‘risks about damage to the banking system,’ Cunliffe said the best way to deal with this would be to make sure a lender was wound down properly through the BOE’s resolution framework rather than restricting consumers’ access to a safe asset,” the article says.
- FTX: Top FTX executive Nishad Singh pleaded guilty this week to criminal charges and agreed to cooperate with prosecutors in the case against Sam Bankman-Fried.
White House Unveils Cyber Strategy
The White House this week released the new National Cybersecurity Strategy. It supports harmonizing regulations, improving oversight of cloud and technology providers and strengthening public-private coordination. It also describes two fundamental shifts in the government’s cybersecurity approach: shifting the responsibility to defend cyberspace away from the end user and toward the owners and operators of critical infrastructure and tech firms; and working to balance short- and long-term objectives to foster resilience and security by design. Here are other key highlights:
- Regulatory emphasis: The strategy calls for regulations across critical infrastructure sectors to include minimum cybersecurity practices, leveraging the NIST Cybersecurity Framework and CISA’s cybersecurity performance goals.
- Harmonization – It calls on regulators to address conflicting, duplicative or burdensome regulations and to work together to minimize harm.
- Public–private collaboration – It calls for creating a “network of networks” by combining organizational collaboration with technology-enabled connectivity to drive collective and synchronized activities.
- Intelligence sharing – It calls to increase the speed and scale of intelligence sharing with the private sector.
- The strategy would also shift liability for insecure software to developers; assess the need for a federal cyber insurance backstop; and prioritize and accelerate investments to protect systems and encryption against quantum computing threats.
- BPI’s take: BPI issued a statement in response to the strategy release.
BPI-Columbia Bank Regulation Conference Explores Business Cycle, Buffers
The seventh annual Conference on Bank Regulation of the Bank Policy Institute & Columbia University School of International and Public Affairs took place on March 1, 2023. Each year, the conference brings together academics, banking agency economists, and market participants to discuss the latest research on banking and bank regulation. The keynote this year was delivered by Randal Quarles, and this year’s theme was bank regulation and the business cycle. The conference covered capital dynamics and regulations, countercyclical capital buffers, evidence on temporary regulatory actions, and what can be expected for bank regulation. One broad takeaway was that releasable buffers like the countercyclical capital buffer are effective in supporting in reducing procyclicality, but judgmental buffers like the capital conservation buffer are not. Another recurrent message was that post-GFC bank regulations have been performing well but can always use improvements and updates.
The Future of SEC Record-keeping Enforcement? Bloomberg’s Levine Explores
A February newsletter piece from Bloomberg’s “Money Stuff” by Matt Levine discusses what might happen if the SEC’s current enforcement efforts targeting bankers’ use of messaging apps on personal cellphones might one day be applied to new technologies like virtual reality. In a few years, “technology — and the SEC’s interpretation of the rules — will have advanced to the point that banks will get fined if their bankers talk about business with clients on the golf course. ‘You should have been wearing your bank-issued virtual reality headset and recorded the conversation,’ the SEC will say, or I guess ‘you should have played golf in your bank’s official metaverse, which records all golf conversations for compliance review, rather than on a physical golf course.’ The golf course is an unofficial channel! No business allowed!” Levine wrote.
Robust Bank Regulation Offers Model for Administration’s Digital Asset Priorities
BPI and the American Bankers Association filed a comment this week with the White House Office of Science and Technology Policy in response to its effort to establish digital asset research and development priorities. This request for input continues the Administration’s “whole of government” approach to fostering responsible innovation, as outlined in recent Executive Orders.
“Banks continue to lead the way in responsible innovation in the financial services sector while nonbank crypto firms continue to collapse,” stated the Associations. “The rules and regulations designed to preserve financial stability and protect customers and investors, coupled with effective risk management capabilities, help ensure that banks are well-equipped to manage any risks associated with using novel technologies.”
The letter calls on policymakers to distinguish among digital assets, cryptocurrencies, and tokenized assets, as well as the underlying distributed ledger technology and blockchain infrastructure, which may differ in use across functions and activities. It also encourages the Administration to acknowledge existing innovations underway at America’s banks and the rules and safeguards already in place that allow banks to innovate safely. Learn more, including the trades’ recommendations, here.
BPI Encourages NIST to Elevate Governance, Supply Chain Risk Management in Updates to Cyber Framework
BPI responded Friday to NIST’s Cybersecurity Framework 2.0 Concept Paper: Potential Significant Updates to the Cybersecurity Framework. BPI is encouraged by NIST’s plan to elevate governance to a new function and to emphasize the importance of supply chain risk management, the letter said. The letter references the Cyber Risk Institute (CRI) Financial Sector Profile, which consolidates existing financial sector regulatory requirements and other standards such as ISO into a unified approach for assessing cyber risk. Governance promotes organizational structures, policies and oversight that support an effective cyber risk management program, and cyber risk management must include critical third parties and vendors in the supply chain.
Multifactor Authentication: Opportunities and Challenges
A new BITS report published this week examines the benefits of multifactor authentication and seeks to establish an industry consensus on access controls and user verification. This report comes at a point when multifactor authentication is increasingly common and federal and state governments work to carve out new rules governing these security measures.
- Key highlights: The report addresses the benefits of multifactor authentication, identifies challenges institutions must consider and explains why a risk-based approach is the optimal solution for achieving the right balance between threat mitigation, operational risk and customer convenience.
To learn more, click here.
Behind the Numbers: The Banking Agencies’ Shared National Credit Exam
Last Friday, the Fed, FDIC, and OCC released the results of the 2022 Shared National Credit (SNC) exam, which showed considerable improvement in syndicated loan performance, especially loans held by banks. The percentage of loans rated “special mention or classified” dropped from 10.6% of commitments in 2021 to 7.0% in 2022. For U.S. banks the decline was from 6.0 percent to 3.2 percent. At nonbanks, the share is 19.2.
Nonbanks’ share of troubled loans is probably higher because they specialize in the riskier end of syndicated lending. The higher share of troubled loans held by nonbanks likely reflects nonbanks’ different business model. Only 5 percent of loan commitments by nonbanks is investment grade; that fraction is 11 times higher for banks.
M&T Bank Unveils Harlem Multicultural Small Business Innovation Lab
M&T Bank this week announced its Harlem Multicultural Small Business Innovation Lab, a six-week program designed to support local entrepreneurs from diverse backgrounds with guidance and resources to help them start and grow businesses. The program is held in collaboration with Carver Federal Savings Bank.