BPInsights: May 20, 2023 - Bank Policy Institute

Regional Banks Power Small Businesses, Economic Growth

Regional banks serve as a vital engine of economic growth, accounting for nearly one-third of small business bank lending. Small businesses themselves play a pivotal role in the U.S. economy by generating two out of every three new jobs in the country. Their inherent nimbleness enables them to innovate and serve their communities in ways that larger firms may struggle to achieve. Thus, it is critical to empower banks to provide robust support to small businesses, recognizing their critical contribution to the economy.

Wide-ranging footprint: Regional banks originate large shares of small-business loans per capita in several regions across the United States, particularly the Northeast, South, West and certain parts of the Midwest.
Pandemic support: Regional banks played a crucial role in disbursing Paycheck Protection Program loans to support small businesses during the pandemic, accounting for about 25 percent of all PPP loans in dollar amounts.

These benefits should be front and center as policymakers contemplate potential changes to the regulatory framework, including capital and liquidity rules, for regional banks in light of SVB’s recent failure. However, Congressional testimony this week by the Federal Reserve’s Michael Barr, the FDIC’s Martin Gruenberg and the OCC’s Michael Hsu appears to overlook potential costs associated with intensified regulatory requirements for regional banks, including harmful effects on the availability and cost of credit for small businesses.

Other policy paths could provide more benefits without such considerable costs, such as the Fed providing liquidity to solvent banks experiencing runs or the FDIC enhancing and modernizing its failed-bank resolution process.

Bottom line: Policymakers considering potential increases in capital and liquidity requirements for regional banks should keep in mind their critical role as drivers of economic prosperity in their communities. Any requirement that regional banks maintain even more capital or more liquid assets would come with significant costs as well as potential benefits, and policymakers must consider such tradeoffs carefully.

Five Key Things

1. 7 Key Takeaways from Bank Regulators’ Hill Hearings

The Federal Reserve’s Michael Barr, the OCC’s Michael Hsu and the FDIC’s Martin Gruenberg testified at House and Senate oversight hearings this week. Here are seven notable highlights from their testimony.

Capital timing: Vice Chair for SupervisionMichael Barr said at the House Financial Services Committee hearing that capital requirement proposals will be proposed in the summer and go through notice-and-comment rulemaking and include a transition period, he said. “I expect that this summer that holistic review will be complete and the interagency process with respect to the Basel III Endgame will also be complete and we’ll be able to speak about those issues in detail,” Barr said. Rep. Andy Barr (R-KY) emphasized to Vice Chair for Supervision Barr that operational risk differences in banks’ business models should inform bank capital regulatory changes. VCS Barr also said the Fed plans to issue a proposal about multiple shocks in stress testing going forward.
The wrong target: A perceived connection between capital requirements and SVB’s failure drew pushback from Rep. William Timmons (R-SC): “SVB did not fail because of inadequate regulatory capital,” he said. “We use the term ‘well capitalized’ to describe a bank that exceeds our capital requirements as they currently exist,” Vice Chair Barr said. “It doesn’t make a comment with respect to whether those are the appropriate rules, and that’s what we’re exploring as part of this review and part of the joint work that the three agencies are taking with respect to the Basel III Endgame.” Other lawmakers objected to the notion of blaming tailoring for SVB’s failure. “I think that argument just falls on its face,” Rep. French Hill (R-AR) said, noting that the diversity of banks in the U.S. banking system is a strength.
Supervision: “What we’re hearing today is scapegoating,” Banking Committee Ranking Member Tim Scott (R-SC) said at the Senate hearing. “We’re dancing around the obvious problem that we’re not looking in the mirror and blaming yourselves.” Scott added that “I’m struck by the fact that the Fed was able to issue 31 supervisory findings with the tools you already have and yet somehow, they need more.” Senator J.D. Vance (R-OH) suggested that the San Francisco Fed supervisors were not focused on the most important financial risks. “I really worry that the more that the regulators are focused on things that have nothing to do with systemic or individual financial risk, the less and less safe our financial system is going to be,” he said. Senator Jon Tester (D-MT) noted that under tailoring, regulators maintained the ability to “drop the hammer” on banks breaking rules. “We have ample discretion under S.2155 to take a risk-based approach to supervision,” Vice Chair Barr said.
M&A: The regulators also received questions about slow merger reviews, which can have harmful consequences. “Markets can handle good news, markets can handle bad news, but what markets can’t handle is inconsistency,” Rep. John Rose (R-TN) said. In response to questions about a recent deal termination in the absence of regulatory approval timelines, Hsu said “different transactions have different features. Some of them can be dealt with more quickly than others.” He added that the banking agencies are working to ensure the M&A framework is “updated and modernized for today’s environment.”
On the horizon: The Fed is considering requiring banks over $100 billion in assets to include unrealized losses and gains on available-for-sale securities in regulatory capital (essentially, eliminating the “AOCI filter” for such banks), Vice Chair Barr said. Such a change would go through notice and comment and be subject to a transition period, he said. He also said the central bank is looking at the rules for when a bank crosses into a more stringent oversight category. “We are focused on simplifying the transition rules and making sure that firms, when they cross that threshold, are able to be ready to apply … those new standards when they cross the threshold.”
Community impact: Rep. David Scott (D-GA) asked Vice Chair Barr if the Fed is fully analyzing the potential impacts of capital changes on small businesses and low- and moderate-income communities. Ranking Member Scott also raised questions at the Senate hearing about the effects of potential new regulations for credit availability. Senator Tester expressed concern that new regulatory changes to the tailoring framework would impose costs on smaller banks. “I just want to make sure that doesn’t bleed down,” he said. On tailoring, Tester said “I think regulation needs to fit the risk.”
Short selling: “Maybe a fulsome look [at short selling] … might be something that we could collaborate on,” Senator Mark Warner (D-VA) said.

2. Bowman Calls for Thoughtful Approach to Regulatory Revisions

Federal Reserve Governor Michelle Bowman reiterated in a speech this week the need to approach any post-SVB regulatory changes with careful consideration. Any revisions to the regulatory framework should be targeted, she said. “I have also heard calls for broad, fundamental reforms for the past several years, shifting away from tailoring and risk-based supervision,” Bowman said. “I believe this is the wrong direction for any conversation about banking reform. The unique nature and business models of the banks that recently failed, in my view, do not justify imposing new, overly complex regulatory and supervisory expectations on a broad range of banks.”

Range of sizes: Bowman observed that applying complex regulatory requirements to banks with simpler business models could drive consolidation. She expressed support for a regulatory framework that enables banks of all sizes to thrive. “The American economy relies on a broad and diverse range of businesses supported by a broad and diverse range of banks,” she said.
Readiness: Banks should take steps to ensure they can access Fed lending under stress if necessary, Bowman said. (SVB struggled to obtain access to Fed lending that could have helped its situation.) “I strongly encourage bankers to consider creating a plan to handle liquidity needs during times of unexpected stress—and then test the ability to execute the plans,” Bowman said. “Adverse conditions can escalate quickly, and influences beyond a bank management’s control, including irrational actors, can impact your business in very short order.” She urged banks to understand in advance the necessary steps to enable borrowing from the discount window.
Independent probe: Bowman reiterated her call for an independent review of events surrounding recent bank failures that should be broader in scope than the Fed’s SVB report.
The solution: “The strong set of laws and regulations we have today suggests that the problems in the banking system require a targeted solution, one focused on actual risks, on improvement of supervision and risk management, and on prompt remediation of supervisory issues,” Bowman said. Rather than eliminating risk-based supervision and regulatory tailoring, policymakers should consider targeted adjustments to the framework and ensure supervisors focus on critical issues.

3. Joint Economic Committee Republican Report: Tailoring Liquidity Rules Did Not Cause SVB Failure

Tailored liquidity requirements under S.2155 did not cause SVB’s demise, according to a report released this week by the Joint Economic Committee’s Republicans. The pre-S.2155 liquidity rules would not have enabled SVB to withstand the billions of dollars in deposit outflows that it experienced in March, the report said. “No reasonable bank liquidity requirement can defend against outflows of this speed and size,” the report said, quoting an academic estimate that a 200 percent LCR would have been required for SVB to meet outflows of that massive size. “Some have argued that subjecting SVB to an LCR requirement would have raised warning signs for supervisors,” the report notes. “However, even without an LCR requirement, supervisors were already aware of the significant funding and liquidity risks at SVB.” The report also noted that under the tailoring law, the Fed maintained the ability to apply heightened oversight to SVB.

4. SEC’s New Custody Rule Threatens to Increase Investment Costs, Reduce Returns

The SEC is proposing major policy changes that will increase investment fees and lower returns on retirement accounts and other investments. It’s doing so by dramatically altering its rules for how registered investment advisors handle clients’ assets, known as the “Custody Rule.” These costs won’t just affect institutional investors. If you’ve ever worked with a financial advisor or invested money through a 401(k) account or pension fund, you’ve probably benefited from bank custody services.

These changes were reputedly spurred by concerns about crypto and other digital assets; however, the SEC overshot its objective and is rushing through a massive overhaul that will fundamentally interfere with banks’ existing business practices by restricting deposits, increasing custodian liability and forcing banks into a supervisory role over investment advisors. These added costs will increase administrative expenses on investments and may significantly reduce 401(k) and other investment returns. For perspective on how administrative costs affect returns, $100,000 invested over 20 years would earn $10,000 less for every 25-basis-point increase in administrative fees, as estimated by the SEC.

To learn more about how this rule could raise costs for savers, click here.

5. Failed-Bank Chiefs Face Capitol Hill Scrutiny

The former top executives of failed banks SVB and Signature testified before House and Senate banking panels this week in the wake of their banks’ collapses. Former First Republic CEO Michael Roffler also testified before subcommittees of the House Financial Services Committee on Wednesday. Here are some highlights.

Anomalies: Senate Banking Committee Ranking Member Tim Scott (R-SC) noted that SVB was an “anomaly.” “For the vast majority of our financial institutions, they are well run,” Scott said. “Our banking system is strong, and your money is safe.” He placed particular emphasis on regional banks – “our true regional institutions are run by smart, competent individuals,” he said.
Supervisory failure: Multiple lawmakers from both parties noted the presence of a supervisory failure. “Later this week, we’ll obviously have a chance to look into supervision,” Senator Mark Warner (D-VA) said. “However, the further we get into these postmortems it feels to me … that there was a failure.” Senator Jon Tester (D-MT) expressed similar sentiments: “The regulators should have been standing on your front doorstep, not allowing you to go through the door until you fix these problems.”
Tailoring: Tester added that “I don’t want the regulators to overreact” and punish banks that follow regulatory requirements. Senator Steve Daines (R-MT) said the Barr report’s assertion that tailoring is to blame is “an overly broad conclusion.” Rep. Bill Huizenga (R-MI) said at a House hearing that “the failure of your banks was a result of failed supervision, under [Michael Barr’s] watch,” but “federal regulators will attempt to use these bank failures to exercise more and more authority well outside the bounds that Congress established for them. And the notion that these failures were a result of regulatory changes is unfounded.”
Other topics: Lawmakers also discussed the role of social media in spurring a run, SVB’s rapid growth and the role of board governance. “Respectfully, if you had this many notices from the examiners, I would have thought somebody from the board would have been calling time-out,” Warner said at the Senate hearing. “This is a serious issue.” “We’re looking not just at what would have appeared to be a failure by management but by the boards as well,” Senator Mike Rounds (R-SD) said. Lawmakers also scrutinized the details and timing of SVB’s communications with supervisors. Former SVB CEO Gregory Becker defended the institution as having been “very responsive” to regulators.

In Case You Missed It

Tester, Tillis Call for Independent Review of Bank Failures

Senators Jon Tester (D-MT) and Thom Tillis (R-NC) this week called on President Biden to appoint an independent investigator to probe recent bank failures. The two Banking Committee members expressed concern about the recent failures of SVB, Signature Bank and First Republic Bank and the regulatory reviews of them. The recent federal regulatory reviews are insufficient, given the broader market impact and unanswered questions that remain, the lawmakers wrote in a letter to President Biden. “Though the regulatory agencies tasked with overseeing our financial institutions have released a series of internal reports examining causes, failures, and corrective measures, we believe an independent examination that covers the full jurisdictional scope of these failures, led by non-partisan experts, is critically important,” they wrote. “Self-reflection, while appreciated, is insufficient to ensure stressors to our financial system of this magnitude are not repeated.” An independent review would benefit taxpayers and help restore confidence in the U.S. banking system, they said.

Tailoring, Examination: BPI’s Baer Joins Banking With Interest Podcast

BPI President and CEO Greg Baer joined Rob Blackwell’s Banking with Interest podcast this week to discuss regulation and supervision in the wake of the SVB failure. Topics of discussion included examination focuses, the broader context of the SVB failure, regulatory tailoring and liquidity rules. Baer also discussed various CFPB policies in the works, such as the Bureau’s late fee proposal.

Fed Releases Latest Regulation, Supervision Report

The Federal Reserve this week released its latest semiannual supervision and regulation report, the first one since SVB’s failure. The report provides a high-level overview of the health of the banking system, Fed supervisory activities and regulatory developments and priorities including for large-bank supervision. Here are some key points.

Risk management: In anticipation of a “more challenging banking environment,” Fed examiners focused in 2022 on evaluating banks’ risk management in “addressing the impact of higher interest rates on liquidity, asset values, and credit quality,” according to the report. (This statement strikes an interesting contrast in light of SVB’s examiners’ apparent emphasis on other issues rather than the core problem of interest-rate risk.)
Fed lending: The report notes that bank risk management practices could include building capital and liquidity as needed and being ready to use available sources of funding, including the Fed’s discount window and Bank Term Funding Program. The acknowledgment of Fed lending programs is notable because they are excluded in the context of regulatory tests — or even worse, discouraged and stigmatized – as a source of bank funding under stress.
Interest rate risk: The Fed has ramped up supervisory activities at community and regional banks with elevated interest rate risk exposures, according to the report. For such banks “with significant securities depreciation or otherwise exhibiting elevated interest rate risk, the Federal Reserve is conducting targeted examinations to assess the adequacy of their liquidity and interest rate risk management,” the report said. It also noted that examiners have increased the frequency and depth of monitoring of funding positions of certain banks.
Other focuses: Examination activities have been directed toward assessing investment securities’ valuation, deposit trends, diversity of funding sources and adequacy of contingency funding plans. State member banks with high concentrations of commercial real estate lending have undergone more in-depth examinations, according to the report. And the Fed has been monitoring banks that are engaging in crypto- or fintech-related activities.
Regulation: The section on regulation mentions seven rulemakings and statements since the last report was published, such as those addressing climate risk and several addressing crypto asset risk.
Barr report: This report summarizes the findings and recommendations of the Barr report on SVB. “The Federal Reserve also welcomes external reviews of SVB’s failure, as well as congressional oversight, and intends to take other perspectives into account as it considers changes to its framework of bank supervision and regulation to ensure that the banking system remains strong and resilient,” the Supervision and Regulation Report states.
Large bank supervisory priorities: Supervisory priorities for large banks included interest rate risk, credit risk and liquidity risk, including changes in deposits and their effects. For a full list, see p. 18 of the report.

The Crypto Ledger

U.S. crypto exchanges, including Coinbase and Gemini, are setting up offshore marketplaces as a U.S. regulatory crackdown looms, according to the Financial Times. The House Financial Services Committee’s Subcommittee on Digital Assets, Financial Technology and Inclusion held a hearing this week on stablecoin legislation. Here’s what’s new in crypto.

EU: The European Council has adopted a regulation on markets in crypto assets (MiCA). The policy sets an EU-level legal framework for the crypto sector for the first time, according to the Council this week. The new rules cover issuers of stablecoins, utility tokens, asset-referenced tokens, as well as wallets, trading venues and other such service providers.
Ripple: A federal judge this week rejected the SEC’s request to seal documents related to a speech on crypto by a former SEC official. The request came as part of the SEC’s case against crypto firm Ripple Labs. The 2018 speech by former Corporate Finance Division Director Bill Hinman has sparked debate in the long-running legal battle between the SEC and Ripple.
Tether: Tether will invest as much as 15 percent of its profits regularly in bitcoin “as part of a strategy to diversify its reserves,” Bloomberg reported this week. Starting this month, Tether’s bitcoin purchases will be considered additional holdings on top of minimum assets held to back its USDT token and other stablecoins, according to the article.
Lay of the land: A recent BIS Financial Stability Institute paper gives an overview of policy measures taken in 19 jurisdictions to address the risks associated with crypto and blockchain activities.

Secretary of the Treasury Janet Yellen’s Meeting with the Bank Policy Institute

The U.S. Department of the Treasury published the following readout on Thursday, May 18:

U.S. Secretary of the Treasury Janet L. Yellen met with more than two dozen CEOs and executives convened by the Bank Policy Institute (BPI) to discuss the current state of the economy and President Biden’s economic agenda. Secretary Yellen reaffirmed the strength and soundness of the U.S. banking system, noting that it remains well-capitalized with strong liquidity. She noted that decisive federal action taken by regulators and the Administration in March to protect depositors helped to strengthen public confidence in the banking system and mitigate financial contagion. Secretary Yellen thanked many of the participants for their leadership and support in responding to these market developments. And she made clear that the Treasury Department continues to closely monitor conditions across the banking sector.

Secretary Yellen also discussed the urgent need for Congress to address the debt limit and underscored the real and severe consequences of default for the banking system and the domestic and global economy. She outlined how a failure to raise or suspend the debt limit would be catastrophic for the financial system, as well as American families and businesses, and underscored the Administration’s belief that the debt limit should be addressed without delay.