BPInsights: May 27, 2023

Shedding Light on Supervision

BPI Senior Fellow Jeremy Newell testified this week before the House Oversight & Accountability Committee’s Subcommittee on Health Care and Financial Services at a hearing entitled “A Failure of Supervision: Bank Failures and the San Francisco Federal Reserve.” Newell’s testimony offers key takeaways on the Federal Reserve’s supervision of Silicon Valley Bank. The materials that the Fed has published so far depict a supervisory culture that focuses on process at the expense of addressing core financial risks, the testimony states.

  • Key quote: “Taken together, the picture that we do have today strongly suggests that the Federal Reserve’s supervision of SVB may have been emblematic of a larger culture of bank supervision that has increasingly lost its way, becoming distracted from its core mission of scrutinizing bank safety and soundness and resembling something more akin to examination-as-management consulting,” Newell said in the testimony. “It also suggests that the reforms that are needed don’t simply involve ‘tougher’ supervision or more rules, but instead a broader structural reform of supervisors’ approach that is aimed at ensuring that examiners are better directing their attention and already-considerable supervisory tools to the kinds of core risks to bank financial integrity that led to SVB’s failure.”

Supervision of SVB emphasized compliance processes, governance and immaterial risks rather than key risks to the bank’s financial integrity. Examiners’ directives – matters requiring attention, or MRAs – failed to prioritize or focus on the risks that ultimately led to SVB’s failure. Supervisors failed to use all the tools at their disposal – for example, they did not enforce important enhanced prudential standards for liquidity and risk management, even though they knew SVB was not meeting those standards. And supervisors oriented much of their activity around rating frameworks designed to be subjective, with the result that SVB’s exam ratings often bore no relationship to its actual risk profile. Further analysis is necessary to diagnose and remedy these serious supervision problems, which the Fed’s recent report on SVB does not meaningfully acknowledge.

To learn more about steps the Fed could consider to improve supervision in the wake of SVB – and materials that could give the public a full picture of what happened – click here.

Five Key Things

1. Why an Important Market Risk Capital Standard was Designed the Way It Is

The Fundamental Review of the Trading Book, or FRTB, requirement will be the new market risk capital standard for banks. It is meant to account for the risk of losses in banks’ trading operations. The FRTB is designed to address problems with the existing market risk capital measures under the global Basel capital framework. The current standard is based on a method called value at risk, or VaR, which measures the degree of potential losses in a portfolio over a specific timeframe.

  • Significant impact: Implementing FRTB will dramatically increase large banks’ market risk capital requirements. Recent estimates suggest that the weighted-average market risk capital requirement resulting from the switch to FRTB will increase by 63.2 percent for a relevant group of globally active banks and 69.2 percent for the Global Systemically Important Bank subset of banks in that group. The increase will resonate particularly in the U.S.
  • Global Market Shock: The U.S. bank capital framework includes the Global Market Shock, an element of the Federal Reserve stress tests that captures market risk. For banks subject to this measure, their market risk capital requirements will be calculated by adding the market risk capital charge from the GMS to the charge from the FRTB. This confluence of requirements is significant for banks’ overall capital requirements, which affect bank lending and ultimately economic growth.

This raises questions about potential overlap between the GMS and FRTB. The GMS and the risks it captures are simpler to understand than the formulas in the FRTB’s methodology. A new post from BPI aims to demystify the FRTB Expected Shortfall calculation by working through a simple example step by step, specifying which risks are being captured.

Bottom line: By working through an example in detail, we can see how the new FRTB ES-based capital measure addresses the five problems implicit in market risk capital based on VaR. The FRTB ES methodology may seem mysterious at first glance, but it is really nothing more than a generalization of techniques that have already been applied in the Basel II.5 standard. Although the FRTB fixes the problems with VaR, it also introduces new problems that should be addressed before FRTB implementation. These problems fortunately have simple solutions that do not require any significant changes to the FRTB.

2. BPI Calls on SEC to Better Balance Investor Transparency and Cybersecurity Risks

BPI reiterated comments this week to the SEC concerning its efforts to give investors more transparency into a company’s cybersecurity risk and incident response practices. The SEC has proposed five separate rules since 2022 that would require companies to inform investors of their cybersecurity risk management practices and enhance consumer protections. BPI’s response calls on the SEC to consider these proposals in line with existing rules and regulations and consider amendments to enhance overall security.

“BPI supports investor transparency and is committed to collaborating with the SEC to reach a solution that preserves sound cybersecurity and risk-management practices,” stated Heather Hogsett, senior vice president, technology and risk strategy for BITS — the technology policy division of BPI. “It is incumbent upon the SEC to acknowledge that premature incident disclosure may harm investors, and the Commission should collaborate with other government partners to enhance security and resiliency.”

To learn more about BPI’s recommendations, click here.

3. Recent Bank Turmoil Creates Room for Private Equity, Nonbank Lenders

Recent midsize bank turmoil has created more space for private equity and other nonbank lenders to grow their footprint in the economy, according to a recent Reuters article. Such lenders will likely expand their presence in auto loans, mortgages and construction financing, according to the article.

  • Larger context: The growth of nonbank lending is nothing new, but the recent banking stress could galvanize it – and it’s a cautionary tale for the stability of the financial system. Nonbank lenders tend to pull back rapidly in stressed conditions, which could exacerbate market volatility. They are also subject to much less regulatory oversight than their bank counterparts. And they do not have access to deposit funding.
  • Small business boon: As regulators consider more stringent requirements for midsize U.S. banks, their role as small business growth engines should be top of mind. Changes such as higher capital requirements could jeopardize that support and push even more financial intermediation into the less stable nonbank sector.

4. New Fed Data Paints Picture of Languishing Bank M&A Approvals

The average wait time for Federal Reserve bank M&A approval rose to 87 days in 2022, reaching 96 days in the second half of last year, according to a recent Law360 article that cites a Fed semiannual report. The 87-day average is up from 65 days on average in 2021 and 69 days in 2020. The average approval time in 2022 was the longest since at least 2011, the earliest year covered in the Fed’s publicly available reports, according to the article. The report blamed the slow-moving process on a full plate: the Fed was considering several large and complex deals at the same time last year. Public pushback during M&A reviews has hit a new high and added to delays, according to the report.

  • 91-day rule: The slowdown is notable in the context of the law – a provision of the Bank Holding Company Act requires the Fed to decide on bank deals within 91 days of the filing of a complete application or the deal is otherwise deemed approved. Long wait times have tangible costs, such as employee attrition and investor uncertainty.
  • Context: Bank mergers are considered by the Department of Justice and the banking agencies. They bear some unique characteristics among other industries, including stringent HHI requirements (a standard measure of concentration in M&A review). The DOJ and banking agencies are currently weighing updates to bank merger policy, and banking regulators such as the OCC’s Michael Hsu and the FDIC’s Martin Gruenberg have weighed in on the topic.
  • Tea leaves: A recent Capitol Account piece notes that details of the Administration’s bank M&A policy outlook could become clearer when the DOJ’s antitrust chief, Jonathan Kanter, speaks at a Brookings event next month. Treasury Secretary Janet Yellen recently suggested a more open stance on midsize bank M&A amid recent stress in the sector. “This might be an environment in which we’re going to see more mergers, and you know, that’s something I think the regulators will be open to, if it occurs,” she said in a Reuters interview.

5. OCC Updates Exam Handbook on Liquidity, Supervision

The OCC this week announced changes to the liquidity section of its examination handbook. The changes appear to be in response to recent bank turmoil, such as the run on SVB. The OCC added new sections on Reserve Balances, FHLB Borrowings, Discount Window, Reciprocal Deposits, Sweep Deposits, Management Information Systems and Third-Party Risk Management, and revised titles of other sections – a deposit section now explicitly names “Internet Deposits” and a corporate governance topic now specifies “Accountability.”

These changes came as the OCC also updated its Policies and Procedures Manual with a new section on ramping up supervisory and enforcement scrutiny on banks that exhibit “persistent weaknesses.” (This appears to be related to the supervisory failure at SVB.) The updated document lays out actions the OCC could consider, such as more stringent capital and liquidity requirements, growth restrictions or restrictions on dividend payments. The most intensive actions could include requiring the bank “to simplify or reduce its operations including that the bank reduce its asset size, divest subsidiaries or business lines, or exit from one or more markets of operation.”

  • Deposits: In the updated examination handbook, the OCC added language on “surge deposits” – large inflows such as those during the pandemic in 2020. “The behavior of these surge deposits is difficult to predict and may not be consistent with deposits gathered under normal conditions. Surge deposits may exhibit less stability and have different characteristics than a bank’s typical deposits.” The agency also flags that banks should consider “material changes to the mix of customers or funds providers that may cause funding sources to respond differently to current or future business conditions.”
  • Supervisory scrutiny: Changes more explicitly call for examiners to review prior supervisory activity work papers and letters, and management’s responses to supervisory findings.
  • Accounting: The OCC added a note that a bank’s tangible GAAP equity position may affect counterparty collateral requirements and included a new appendix focused on this issue. Federal Home Loan Banks, broker-dealers and reciprocal deposit programs might face restrictions affecting their ability to lend or place deposits at banks depending on this accounting measure. Elsewhere, the OCC expanded a prior reference to accounting treatment, stating that “Accounting treatment may influence management decisions, based on the impact to balance sheet and income statement reporting”, likely in reference to the recent discussions around AFS and HTM portfolios.
  • Discount window: This new section notes that “Examiners should apply additional scrutiny in assessing funding strategies in banks that place significant reliance on the discount window to meet recurring liquidity needs or liquidity needs over a prolonged period.” The OCC also included other language noting that the Discount Window may be unavailable at times and that the Fed is not required to lend through the discount window.
  • Twitter run: The updated exam handbook includes a reference to social media potentially spurring runs.

In Case You Missed It

What the Fed Minutes Say About Banks

The most recent minutes of the FOMC included several remarks on the banking industry. The comments shed light on how FOMC members and Federal Reserve staff are thinking about recent stresses in the context of their economic outlook. Here are some key highlights. 

  • State of the banking industryand recent turmoil: Fed staff judged that the banking system was sound and resilient despite concerns about profitability at some banks. Deposit outflows from small and midsize banks largely stopped in late March and April. Although stock prices for midsize banks fell further over the period, for most banks this decline appeared to reflect expectations of lower profitability rather than solvency concerns. Banks of all sizes appeared strong going into the period of recent stress, with considerable capital. The majority of the banking system has managed the interest rate risk associated with the drop in value of securities holdings amid rising rates, but some banks experienced stress in the wake of the failures.
    • Key quote: “A number of [FOMC] participants noted that the banking sector was well capitalized overall, and that the most significant issues in the banking system appeared to be limited to a small number of banks with poor risk-management practices or substantial exposure to specific vulnerabilities. These vulnerabilities included significant unrealized losses on assets resulting from rising interest rates, heavy reliance on uninsured deposits, or strained profitability amid higher funding costs. Some participants additionally noted that, because of weak fundamentals for CRE such as high vacancy rates in the office segment, high exposure to such assets was a vulnerability for some banks.”
  • Importance of banks for the outlook: Staff and FOMC participants judged that banking sector developments were important determinants of the outlook, and for risks around the outlook.  The staff expected that “…a further tightening in bank credit conditions, amid already tight financial conditions would lead to a mild recession starting later this year…”.  FOMC participants stated that the “…the degree to which tighter credit conditions for households and businesses resulting from events in the banking sector would weigh on activity and reduce inflation…” was a key factor for whether the Committee would tighten policy further in upcoming meetings. Smaller and midsize businesses dependent on bank financing could feel the effects of any credit tightening in particular.

The Crypto Ledger

Binance commingled customer funds with company revenue in 2020 and 2021, violating U.S. requirements to keep customer money separate, according to a Reuters report citing people familiar with the matter. The totals amounted to billions of dollars and commingling occurred almost daily in accounts Binance held at Silvergate Bank, according to Reuters. While the article states that “Reuters found no evidence that Binance client monies were lost or taken,” it also notes that the Binance flows indicate a lack of internal controls. Binance faces a DOJ investigation and a CFTC lawsuit. Here’s what else is new in crypto.

  • FINRA: The Financial Industry Regulatory Authority approved its first broker-dealer with custody rights for digital asset securities: Prometheum Ember Capital LLC. It also allowed OTC Markets Group to provide trading for crypto securities. The approvals suggest a potential path forward for crypto firms to provide above-board securities services, according to CoinDesk.
  • Fentanyl: A recent research report alleged that Chinese firms selling inputs for fentanyl are accepting payments in bitcoin and Tether. Global supply chains for fentanyl, a scourge of the U.S. opioid crisis, have attracted scrutiny from the Treasury Department in recent years.

The Economist: “The Financial System Is Slipping Into State Control”

“Recent turmoil has pushed the banking system further along the path to state control,” a recent article in The Economist stated. In recent months, government authorities have become more dominant in finance. The piece points out that measures enacted in crisis are hard to remove afterward. “Once inflated, it never quite shrinks back to size. Moreover, potential future expansions in the state’s remit—possibly including much tighter rules on collateral or an unintended shift to a so-called narrow-banking system—can now be glimpsed. How much further will the state expand?”

  • Capital: The article notes that the stringent post-crisis system of risk-weighted capital requirements could make capital less tied to actual risks on bank balance sheets – “Like any attempt to categorise complex things, these risk-weights will often be wrong.”
  • Less bank-like future? “The bigger the backstop, the more reason the government has to dictate what risks banks may take. Therein lies the third source of creeping state control: regulation of asset quality,” the article said. Ultimately, expanding government influence over banking could make banks look less like banks – if banks are forced to hold more short-term government bonds to guard against interest-rate risk, they would move farther from the heart of banking, maturity transformation (transforming short-term deposits into long-term loans).
  • Fed lending: The article highlighted the Fed’s new Bank Term Funding Program, which values securities at par even if they are worth less in the market, as a departure from Walter Bagehot’s central banking principles.

U.S. Bank Promotes Scott Ford to President of Wealth Management

U.S. Bank has promoted wealth management executive Scott Ford to be its new president of Wealth Management, the bank announced recently. Beginning June 1, Ford will lead all of U.S. Bank’s wealth businesses, including Affluent Wealth Management, Private Wealth Management and Ascent Private Capital Management of U.S. Bank. He will also oversee U.S. Bancorp Investments (USBI). Ford previously led the bank’s Affluent Wealth Management business. Prior to joining U.S. Bank in 2021, Ford served as a regional director, Wealth Management at JPMorgan Chase, overseeing their largest wealth region, New York.

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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.