BPInsights: May 18, 2024

Why the Basel Proposal Needs a Comprehensive Quantitative Impact Study and a Reproposal

The Basel proposal has important implications for the cost of loans, market liquidity, custody of assets, the role of banks in the financial system and the overall growth of the U.S. economy. Parsing the proposal’s specific impacts — not just on banks, but on the households and businesses that use their products — is essential and required by law. But a QIS alone isn’t sufficient to address the proposal’s ripple effects on the economy, satisfy legal requirements and remedy the procedural missteps in the process so far. The banking agencies must undertake both a comprehensive impact study of the proposal’s costs and a reproposal of the rule, BPI wrote in a new blog published this week.

  • Procedural mistakes: A normal rulemaking must follow a particular sequencing — first, a quantitative impact study to gather data on a potential rule’s effects; then, a proposed rule providing data and analysis to support its changes; then, a final rule only after considering public comment on both the proposal and the supporting data. The banking agencies skipped important steps or completed them out of sequence, releasing a proposal with no supporting data and conducting a QIS after proposing the rule.
  • What’s happening now: Now, nearly four months after the close of the comment period, the QIS data has yet to be released for public comment, and was not available to inform public comment on the original proposal.
  • Just a starting point: The QIS data serves only as a rough starting point for estimating the total impact of the Basel proposal. The proposal’s effect on bank capital is only part of the story. The much more meaningful story is how those capital changes would affect the bank’s customers, other end users and the real economy. It’s impossible to assess the proposal’s costs and benefits without expanding the QIS to capture these downstream effects.
  • Unsupported by evidence: Other major aspects of the proposal lack grounding in empirical evidence or analysis, such as the elimination of banks’ internal models for calculating capital requirements for credit risk; an increase in capital requirements for mortgage and consumer loans without proper justification; the punitive capital treatment of bank lending to non-publicly-traded businesses, and small and medium-sized businesses; and the significant overlap between the stress tests and the Basel proposal’s capital requirements.

Bottom line: Given these serious data and analytical shortcomings, the only viable path forward is to repropose the rule and provide a comprehensive justification for the proposed changes, including a thorough assessment of the proposal’s expected economic impact and a complete analysis of its relative benefits and costs. This would include modeling banks’ responses to the regulatory changes, assessing the impact on the cost of financial services and potential changes to the probability of a future banking crisis. Additionally, they should also examine the potential migration of financial activities to the nonbank sector and its implications for financial stability.

Five Key Things

1. FDIC Chief Faces Bipartisan Scrutiny at Hearings

After the release of the Cleary report on the FDIC’s workplace misconduct issues, the agency’s Chair Martin Gruenberg was in focus at the prudential regulator oversight hearings this week. The regularly scheduled oversight hearings typically focus on banking rules and policies, but this week’s hearings also offered a chance for lawmakers to question Gruenberg about the report’s alarming findings.

Senate Banking Committee Democrats derided the toxicity but defended Gruenberg’s chairmanship. Senate Banking Committee Chairman Brown described a culture of “serious, long-running problems” and “episodes of harassment, discrimination, other misconduct that no one should ever have to endure” but endorsed Chairman Gruenberg as the person to change the FDIC culture. Similarly, Sen. Catherine Cortez Masto (D-NV) described deep-seated cultural problems at the agency as “a systemic failure over the years.” Rep. Bill Foster (D-IL) has so far been the sole Democratic lawmaker to call for Gruenberg’s resignation. 

Here are some notable exchanges.

  • Leadership: Lawmakers from both parties called into question Gruenberg’s ability to continue leading the agency in light of the report’s revelations. “I’m pissed off, because … employees suffered from racial and gender discrimination, bullying, mistreatment and harassment at the FDIC for years,” said Rep. Gregory Meeks (D-NY). “And as I see in the report, not a single one resulted in a removal, reductions in pay grade, or any discipline more serious than a mere suspension.” Meeks asked: “How can that trust and credibility be returned under current leadership?” Rep. French Hill (R-AR) said it would be “in the best interest of banks and the agency itself and your employees that you stepped down as Chair.” Rep. Ayanna Pressley (D-MA) told Gruenberg, “Personally, I do not have confidence that you can continue to lead in this role because there is a deficit of trust, and your credibility has been undermined to lead the FDIC through the changes it needs to make to affirm the dignity of the survivors of harassment, discrimination, and abuse at your agency.” Sen. Bill Hagerty (R-TN) said “the need for immediate leadership change here is so obvious.” Hagerty went on to say: “Does the ‘Me Too’ movement now have an exception for technical regulations? Chairman Gruenberg, is saving your job more important than protecting the staff and the integrity of the agency that you lead?”
  • Behind-the-scenes prep: Semafor reported this week that former senior aides to Sen. Warren helped Gruenberg prepare for the hearings. “Sen. Elizabeth Warren, known for calling Wall Street executives to task for management failures, has been running a behind-the-scenes campaign to protect a top banking regulator from documented allegations that he presided over a toxic workplace,” the article said. The article reports that CFPB Director Rohit Chopra, who sits on the FDIC board, also helped Gruenberg practice questions.
  • Political context: Democrats like Warren attempted to position Republican concerns as an attempt to thwart their regulatory policy agenda, a somewhat specious argument, given that Democrats control the Senate and could replace him. 
  • Tone at the top: Sen. Katie Britt (R-AL) cited several instances of misconduct during the period of Gruenberg’s leadership and emphasized the FDIC’s culture of bias against female employees. “The FDIC was created to promote confidence in the American financial sector,” Britt said. She asked the OCC’s Michael Hsu, “Do you believe that an agency described as misogynistic, abusive, toxic, instills trust and confidence in the American people?” She also said: “It starts at the top…we need a wholesale change starting at the top.”
  • ‘Do the right thing’: Rep. Jim Himes (D-CT) urged Gruenberg to envision the victims of sexual harassment and other misconduct at the FDIC and respond as if he were speaking directly to them. “I would just ask you … sit with them and persuade them that you’re the right leader, and if they are not persuaded, we don’t matter,” Himes said, referring to the Committee. “I hope you’ll do the right thing.”
  • Accountability: A key theme of the response to Gruenberg was the need for accountability at the FDIC. “You need to fire some people, if you’re going to clean this up,” Rep. Stephen Lynch (D-MA) said at the House hearing. Rep. Ann Wagner (R-MO) told Gruenberg he “should be fired,” and also turned to OCC chief Michael Hsu, asking how he believed that Gruenberg could lead the agency into a cultural transformation.
  • Personal misconduct: Other lawmakers, including House Financial Services Committee Chairman Patrick McHenry (R-NC), emphasized not only the workplace misconduct issues during Gruenberg’s chairmanship but also Gruenberg’s history of angry outbursts toward employees. Gruenberg apologized for the angry behavior and to the victims of sexual misconduct, but some lawmakers appeared dissatisfied with the level of commitment he demonstrated to lasting change.

2. Regulatory Highlights from the Capitol Hill Hearings

Here are some regulatory takeaways from the prudential regulator oversight hearings this week.

  • Basel reproposal: A top concern of lawmakers on both sides of the aisle was the Basel capital proposal. At the House hearing, Chairman McHenry (R-NC) pressed Federal Reserve Vice Chair for Supervision Michael Barr to commit to reproposing the rule for notice and comment. “We haven’t made a decision on process yet,” Barr said. He said they will comply with the Administrative Procedure Act. Rep. French Hill (R-AR) asked Barr about a media report that suggested the agencies would not repropose the rule. “We haven’t made any decision at all with respect to the process,” Barr reiterated in response. Given the deluge of negative comments on the proposal, “why is there even a question whether or not the proposal should be withdrawn in full” and reproposed, said Rep. Andy Barr (R-KY). The necessity of a reproposal was echoed by Sen. Mike Rounds (R-SD) during the Senate hearing.
  • Evidence-based: “I think the reason why there’s been such pushback is that at least early on, there was not … the evidence-based documentation of what would be the cumulative effect of these rules, these rule changes,” Sen. Mark Warner (D-VA) said at the Senate hearing. “I hope before the final rules come out you will make those estimates public.”
  • End user effects: Rep. Frank Lucas (R-OK) expressed concern about the Basel proposal’s effect on costs for farmers and agriculture producers. He specifically emphasized the potential for increased costs on banks’ central clearing of derivatives. Rep. Sean Casten (D-IL) and Rep. Roger Williams (R-TX) also emphasized the rule’s potential effects on clean energy investment and small businesses.
  • Broad, material changes: Vice Chair Barr told Rep. Jim Himes (D-CT) that “we’ll make broad and material changes to the rule. He added that “I expect those to occur across all three areas: operational risk, credit risk, and market risk.  We need to work through that substance—finish working through that substance [and then] turn to the question of what the right process is, but, you know, we’re not on a timetable that is dictated by anything other than getting it right.”
  • Debit interchange: Rep. David Scott (D-GA) said he is concerned about the impact of the Fed’s proposal to lower the debit interchange cap on lower-income customers, who could lose access to free bank accounts and other services as a result.
  • Discount window: Vice Chair Barr alluded to potential changes around the Fed’s discount window. Rep. Brad Sherman (D-CA) asked for confirmation that the amount of collateral banks must pledge to borrow from the discount window “will relate to the amount you’re borrowing from the discount window and not based on the total uninsured deposits of the bank.” Vice Chair Barr did not give a specific confirmation in response. Rep. Young Kim (R-CA) also asked about how the Fed may improve the discount window. “What we have heard from a number of banks is that there are procedural issues in their working with the Discount Window that could be improved,” Barr said. “One of the areas that, for example, we’re working on is, banks said it’d be good to have an online portal.” Rep. Kim also raised concerns about discount window stigma and its limited operations with banks in the Pacific Time Zone.
  • Long-term debt: Rep. Roger Williams (R-TX) said the proposed long-term debt requirement would increase costs for banks and ultimately for consumers without strengthening financial stability. “Imposing such stringent requirements on regional banks not only stifles their ability to lend to small businesses and stimulate local economies, but also undermines the fundamental principles of free market capitalism,” Williams said. He noted the need to tailor the percentage of required long-term debt to an institution’s actual risk profile. Rep. William Timmons (R-SC) said it seems “premature to finalize a long-term debt rule without fully understanding the impacts of Basel III Endgame.”

3. Mergers Involving GSIBs Do Not Inherently Increase Financial Stability Risk

Recent policy proposals by the FDIC and OCC would effectively ban Global Systemically Important Banks from merging. A new BPI analysis explains why such an approach deviates from the law – and why mergers involving GSIBs do not inherently increase risks to the financial system’s stability. In fact, many combinations of a GSIB acquiring a large regional would decrease such risk, according to the Fed’s key measure of banks’ systemic risk.

  • Why it matters: Well-designed merger policy is crucial for fostering a diverse, dynamic banking system. Mergers enable banks to make costly investments in technology, cybersecurity and other important features by allowing them to spread high fixed costs over a larger revenue base. This is especially important as banks are innovating to meet customer demand and compete with fintechs.
  • What the statute says: The Bank Merger Act specifies, as one of five factors, that the federal banking agencies must consider the risk to the stability of the U.S. banking or financial system when reviewing a merger application.
  • What the agencies propose: A recent FDIC proposed policy statement finds that any bank over $100 billion in assets would be “more likely” to present financial stability concerns in an M&A application. The OCC also issued a proposed policy statement finding that a merger application would be unlikely to be approved if the acquirer is a GSIB or a GSIB’s subsidiary, because such an application would “raise supervisory or regulatory concerns.” These prescriptions suggest a merger review approach that departs from the statute and imposes arbitrary size-based thresholds that are unsupported by any data or analysis.
  • What the statute does not say: Federal law does not contain the same prescriptive, size-based restrictions on bank mergers that the FDIC and OCC policy proposals suggest. Congress precludes acquisitions only when the resulting bank would hold more than 10 percent of insured deposits, or more than 10 percent of financial system assets.
  • Diving deeper: BPI used the Fed’s framework for assessing systemic risk – known as the Method 2 score – to evaluate the systemic risk presented by a resulting institution for hypothetical mergers involving GSIBs and large regional banks. The analysis looks at all possible combinations between a U.S. GSIB and a regional bank in Categories II through IV. The analysis finds that
    • A significant portion of all possible combinations between GSIBs and large regional banks would meaningfully reduce the short-term wholesale funding score of the combined bank. This is part of the Method 2 framework that measures a bank’s reliance on short-term wholesale funding, which is considered less stable in a crisis.
    • Despite growth in other risk factors, approximately 43 percent of all possible GSIB-regional bank mergers would lead to a net decrease in the overall Method 2 score. This finding indicates that the resulting institution would have a lower systemic risk profile compared to the GSIB acquirer before the merger. 

Bottom line: This analysis demonstrates that mergers involving GSIBs do not necessarily increase systemic risk and can actually decrease it. It’s worth noting that Congress did not impose any specific prohibitions or presumptions against GSIB-related acquisitions in the relevant statutes, instead taking a more holistic approach. Given this legislative context, the OCC and the FDIC must explain and justify their proposed merger policies with sound analysis consistent with the statute.

4. SEC Considering Reproposal of Custody Rule

The SEC is considering a reproposal of its custody rule (also known as the safeguarding rule), which would have dramatically overhauled bank custody practices and increased investment fees and lower returns on retirement accounts and other investments. SEC Chairman Gary Gensler said this week that he has “asked staff to consider whether it would be appropriate to seek further comment, possibly, on a modified proposal” for the custody rule and another rule related to brokers’ use of artificial intelligence. Capitol Account reported this week that “re-proposals are definitely in the works” and the rules are “likely to be scaled back significantly,” citing sources familiar with the matter.  A reproposal would be a welcome development for market participants across the board, including investors who could have seen higher costs under the proposal.

5. Former CFPB Chief: CFPB Must Stop Manipulating Data to Support its Policy Preferences

Former CFPB Director Kathy Kraninger called on the CFPB to stop manipulating data to create a misleading picture of the credit card market. She focused in particular on the credit card late fee rule. In a recent American Banker op-ed, Kraninger pointed to “cherry-picked data” claiming to show that larger credit card issuers charge much higher interest rates than smaller banks. “A consumer might pause at that conclusion, considering the breadth of the credit card market that can be seen in advertising and everyday use,” wrote Kraninger, now the CEO of the Florida Bankers Association. “An expert knows to question it — with nearly 4,000 credit card issuers and highly differentiated products and pricing, the assertion defies common sense.”

  • Competitive context: Kraninger noted that more context is necessary when including credit unions along with banks in a credit card pricing analysis. Credit unions’ lending rates are capped by law, they are exempt from federal taxes and they face less stringent regulatory requirements than banks, she noted – all factors that differentiate them in a competitive analysis. “Take them out of the equation and the pricing gap between large banks and small banks shrinks dramatically,” she said. A BPI analysis found only marginal pricing gaps between the largest and smaller issuers when controlling for differences due to credit unions, program type and program credit risk profile.
  • ‘Rush job’: The CFPB must evaluate the costs and benefits of potential rules during the rulemaking process and provide data supporting its decisions. “Instead of providing credit card issuer costs in its late fee rulemaking, the CFPB did a rush job, relying on confidential credit card cost data the Fed collects for purposes of stress-testing institutions,” Kraninger said. This data cannot be subject to public input because the Fed is prohibited by law from releasing it, she said, and the data’s limited scope fails to capture the significant cost to banks of managing accounts that are late, but not yet 30 days past due.
  • Bottom line: “The CFPB’s primary job is to stand with consumers and help educate them about the financial choices they face,” Kraninger wrote. “Manipulating data and misleading the public in pursuit of a policy preference is contrary to that mission. Instead, the agency should play it straight and recommit to only sharing relevant and accurate information.”

In Case You Missed It

Supreme Court Finds CFPB Funding Structure Constitutional

The U.S. Supreme Court ruled on Thursday that the CFPB’s funding structure is constitutional. Justice Clarence Thomas wrote the majority opinion in the 7-2 decision, and Justices Samuel Alito and Neil Gorsuch dissented. Both the majority opinion and the dissent drew on centuries of historical context about the funding of government. The question at the heart of the case is whether the CFPB’s funding, which comes from the Federal Reserve instead of from Congressional appropriations, violates the Appropriations Clause of the Constitution.

  • What is an appropriation? The majority opinion concluded that an appropriation, under the Appropriations Clause, is simply a law that authorizes expenditures from a specified source of public money for designated purposes, and that the statute providing the CFPB’s funding meets that requirement. The dissent rejected that line of thinking and concluded that the combination of features in the CFPB funding structure make it unconstitutional even if each or all of those features would be constitutional standing alone.
  • Stepping back: The Supreme Court ruling marks a culmination of years of legal debate about the CFPB’s structure, funding and governance. Critics of the Bureau have contended that without direct Congressional appropriations, the Bureau lacks proper accountability like other agencies. This objection was embodied in Justice Alito’s dissent, which said the Framers of the Constitution would have been “horrified” by the Bureau’s insulation from Congressional appropriations.
  • What’s next: Various challenges to the CFPB have hinged on the outcome of this case, such as a challenge to its Section 1071 small business data rule, with the implementation of some CFPB rules being paused until the ruling. Presumably, such freezes could now be reversed.

Judge Blocks Late Fee Rule From Taking Effect

Late last week a federal judge in Texas granted an injunction blocking the CFPB’s credit card late fee rule from taking effect. A preliminary injunction granted by Judge Mark Pittman of the U.S. District Court for the Northern District of Texas paused the rule’s implementation ahead of its May 14, 2024 effective date. The court based this decision on the 5th Circuit’s ruling that the CFPB’s funding structure is unconstitutional. The Supreme Court ruled on Thursday that the CFPB’s funding is constitutional.

FinCEN, SEC Propose New Money Laundering Requirements for Accounts Opened at Investment Advisers 

FinCEN and the SEC this week jointly proposed new anti-money laundering requirements for registered investment advisers. The measure would impose new customer identification requirements on certain advisers as part of a broader effort to subject more financial firms to money laundering requirements. It follows a FinCEN proposal to subject investment advisers to Bank Secrecy Act requirements.

Regulators to Hold Public Hearing on Capital One-Discover Deal

The Federal Reserve and the OCC this week announced an upcoming joint public hearing on the Capital One-Discover acquisition. The hearing will be held virtually on July 19, and the regulators will solicit oral testimony from members of the public. The announcement follows an extension to May 31 of the deadline for written public comments on the deal.

Fed Releases Supervision and Regulation Report

The Federal Reserve late last week released its regular Supervision and Regulation Report.

  • High-level look: The report indicated that capital has increased in the banking system and liquidity is stable. It also noted that banks have improved their readiness to access the discount window but did not quantify the extent of the improvement.
  • Supervisory ratings: As of Dec. 31, 2023, two-thirds of large financial institutions were meeting supervisory expectations with respect to the (1) capital positions and planning or (2) liquidity risk management and positions, components of the LFI ratings framework. However, supervisors have found weaknesses in interest rate risk and liquidity risk-management practices at several large financial institutions. Some large financial institutions continued to show weaknesses in the governance and controls component of the LFI ratings framework related to operational resilience, cybersecurity, and BSA/AML compliance. Outstanding supervisory findings at large financial institutions have increased in the second half of 2023, which contributes to the higher percentage of firms being rated less than satisfactory. Supervisory findings related to weaknesses in liquidity and interest rate risk management practices increased , but the increases were not quantified. In any event, governance and controls findings still represent approximately two-thirds of outstanding issues.
  • Supervisory priorities: For large financial institutions, the Fed’s supervisory priorities include: (1) risk management practices associated with interest rate, market, and counterparty risk; (2) internal liquidity stress tests, including “changes to deposit stress testing segmentation and runoff rate assumptions”; (3) remediation efforts on previous supervisory findings. 
  • Overall condition of the banking sector: The report notes that although the sector “remains sound and resilient” with banks “continu[ing] to report capital and liquidity levels above applicable regulatory requirements,” delinquency rates for some commercial real estate loans and some consumer loans have “increased to above pre-pandemic levels,” prompting banks to “boost[] the allowance for credit losses in anticipation of further deterioration in asset quality.”
  • BPI published a blog post providing an assessment of the Fed’s late 2023 Supervision and Regulation Report and offering recommendations for future reports.

The Crypto Ledger

Here’s the latest in crypto.

  • Digital assets custody: The Senate on Thursday passed legislation to invalidate the SEC’s Staff Accounting Bulletin 121, which would impose significant costs on banks holding digital assets in custody for clients. The Congressional Review Act measure, which received bipartisan support, now heads to the President’s desk. In a Statement of Policy, the White House indicated that the President would plan to veto the measure.
  • Tornado: Tornado Cash developer Alexey Pertsev was found guilty of money laundering and sentenced to more than five years in prison by a Dutch court this week.
  • Binance VIPs: Binance had hired an investigative team to clean up its operations – but then fired the investigator after the team found that “VIP” clients engaged in market manipulation, according to the Wall Street Journal.
  • FTX bankruptcy: Bankrupt crypto exchange FTX will make its customers whole, but not in the way some of them want – a Bloomberg article reports that some FTX customers would have preferred to get their crypto back instead of being paid out in U.S. dollars.

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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.