BPInsights: November 12, 2022

Stories Driving the Week

As Regulators Implement Basel Bank Capital Changes, They Should Look to Real-World Experience, Not Theory

U.S. banking regulators will soon implement the most recent Basel Accord, an overhaul of bank capital requirements. These changes resonate far beyond the banking sector: they will affect the cost of credit for small businesses, levels of lending to low- and middle-income households, market liquidity in fixed income markets and the growth of the economy on the cusp of a potential recession. Calibrating them to reduce risks while minimizing costs to economic growth is critical.

While debates about optimal capital levels in the wake of the GFC were necessarily based on academic models, we now have a dozen years of experience with the post-GFC capital regime, and any assessment at this point should be based on reality, not theory.

Background: The Basel Accord aims to ensure that all countries impose similar capital requirements on banks to maintain a level playing field. The U.S., in practice, has a ‘gold-plated’ capital regime that layers additional stringency on its banks:

• U.S. regulators have doubled the capital surcharge that Basel imposes on the largest banks.
• For those banks, the supplementary leverage ratio has been raised from 3 percent to 5 percent at the holding company level and doubled to 6 percent at the bank level.
• Through annual stress tests, the Fed has imposed another capital surcharge on all large U.S. banks that is 1.6x higher than its parallel in the Basel Accord as applied in non-U.S. jurisdictions.
• Stress tests introduce considerable volatility in capital requirements, causing banks to hold additional capital as a buffer.

The big question: The key question — whether there is evidence that U.S. banks require additional capital to reduce the risk of insolvency or financial instability — used to be a theoretical one, but can now be answered by ample real-world evidence, which all points in the same direction. That evidence is where policymakers considering Basel implementation should look, rather than models of optimal capital levels in the academic literature.

• Over the past 12 years through good times and bad, there has never been the slightest indication that any major U.S. bank was in danger of insolvency.
• The banking industry demonstrated resilience throughout the COVID-19 crisis, weathering stringent Fed stress tests and real-world stress tests alike. Banks funded the largest increase in corporate liquidity demand as the government was preparing its response while the stress tests assumed no fiscal support that would result in lower bank losses.
• Large banks experienced no difficulty selling long-term debt they issued in 2020, despite appropriately wider bond spreads, even though bank debt was the only corporate debt not backed by the Fed. This demonstrates that the market concurred with the Fed’s conclusion that large banks had ample capital.
• For a dozen years, using actual bank balance sheets, banks have demonstrated ample capital. In the most recent test, banks had more than $2.8 trillion of loss absorbency resources, equivalent to 9x the $300 billion in projected net losses.

EU Basel implementation delay: European Union members agreed to delay implementation of the final round of Basel III rules until 2025, according to Reuters this week. EU states will negotiate a final deal with the European Parliament in early 2023, with further possible changes. The deliberate timeline would enable more flexibility for European banks to support the continent’s economy at a challenging time. An updated proposal could allow more flexibility for property loans and move fewer subordinated debt offerings to higher risk weights, according to Bloomberg, as well as changes to the proposal on requirements for branches of foreign banks, and discretion for member states to apply the output floor at the highest level of consolidation.

FTX’s Downward Spiral

Crypto exchange FTX suffered a liquidity crisis this week as investor fears about founder Sam Bankman-Fried’s trading firm Alameda Research prompted massive redemptions – essentially, a crypto run. The FTX nosedive led to a rescue proposal by rival exchange Binance, which was withdrawn later in the week, and culminated in Bankman-Fried’s resignation and FTX’s bankruptcy. News of FTX’s public implosion roiled the crypto market and obliterated the personal fortune of Bankman-Fried, who is known for his policy advocacy and his prominent rescues of other failing crypto firms. The tables turned as FTX sought a multibillion-dollar rescue. FTX had approached crypto exchange Kraken about a potential rescue deal, Axios reported.

As FTX files for bankruptcy after failing to secure a bailout, policymakers should ensure they do not embed crypto firms in the heart of the financial system by giving them Fed accounts; otherwise the next crisis in the cryptoverse could threaten financial stability.

• Alameda: FTX lent billions of dollars of customer assets — more than half its customer funds — to fund risky bets by Bankman-Fried’s trading firm Alameda Research, the Wall Street Journal reported this week. Bankman-Fried told investors that Alameda owes FTX about $10 billion, according to the article. On Thursday, Bloomberg reported that Bankman-Fried is closing Alameda.
• Trust and proof: Binance CEO Changpeng Zhao tweeted this week that his exchange would demonstrate “proof of reserves” to enhance transparency.
• The backdrop: FTX’s liquidity crisis followed a Twitter feud between the rival chief executives that brought their tensions into public view. Binance chief Zhao tweeted that Binance would sell its holdings of the FTX token FTT for risk-management purposes. The context of that tweet was a CoinDesk article alleging that much of the balance sheet of Bankman-Fried’s Alameda Research was made up of the FTT token. Bankman-Fried dismissed the concerns as “false rumors.”
• Probes: FTX faces scrutiny from several government agencies, including the SEC, CFTC and DOJ. “We will continue to do our job as a cop on the beat,” SEC Chairman Gary Gensler said at an event hosted on Wednesday, according to the WSJ. “The runway is getting shorter for some of these intermediaries, I have to say.”
• Perspective: The downfall of FTX, one of the world’s most prominent crypto giants, has left the financial system unscathed, because trading one token for another is unconnected to the real economy. 
• Master accounts: But it could have threatened financial stability if the firms involved had been embedded in the U.S. payments system via Federal Reserve master accounts. Policymakers should keep such threats in mind as they formulate new rules for crypto: Don’t bail out a failing industry by giving it Fed account access and linking it to the regulated financial system.

Pig Butchering, Fake Romance: CFPB Highlights Crypto Fraud, Scams

The CFPB this week called attention to crypto scams and fraud in a new complaint bulletin. Consumers’ complaints ranged from hacks, fraud and scams to trouble with account access. The agency warned consumers to be wary of romance scams, “pig butchering” scams, crypto asset volatility and other risks.

Banks Have Clear Authority to Issue Digital Deposits, TCH Whitepaper Explains

Banks have the legal authority to issue stablecoins and deposits in digital form, a new whitepaper released by The Clearing House explains. The whitepaper uses the term “stablecoin” and “digitized deposit” interchangeably.

Context: The OCC issued letters in 2020 and 2021 clarifying that national banks have the authority to issue and exchange stablecoins. These letters are consistent with federal banking law (the National Bank Act) and with multiple court decisions and regulatory determinations. However, the banking agencies have recently called for banks to provide notice to – or obtain a supervisory non-objection from – their supervisors before engaging in certain digital asset activities. This requirement effectively precludes banks from offering traditional banking products in novel ways — like deposits — which they have express authority to provide. Furthermore, permitting banks to innovate in offering traditional banking products will protect consumers, as banks are subject to the highest levels of regulatory scrutiny and have substantial experience adopting new technologies into the financial system. But, if banks are prohibited from using new technologies to offer these products, including digitized deposits, consumers will have no choice but to use less-regulated entities for those products.

• Core functions: National banks have always been allowed to develop innovative mechanisms to engage in the traditional core functions of the banking business such as taking deposits and acting as financial intermediaries.
• Benefits: Banks and their customers can benefit from the efficiency of digital deposits and other applications of blockchain technology in the provision of traditional banking services. Offering these products within the extensive regulatory framework under which banks operate will help to ensure that the products are offered consistent with safety and soundness and that consumers are protected.
• Bottom line: Banks have the authority under the law to issue stablecoins or digitized deposits. Banking regulators should not preclude banks from engaging in these legally permissible activities. “[G]iven the stability, safety and transparency of banks, regulators should enable banks to enter into stablecoin issuance by working with them to develop a clear and consistent regulatory regime, and not discourage them based on untenable legal analysis or nebulous safety and soundness concerns,” the paper says.

Fed’s Waller: Case for U.S. CBDC ‘Not Yet Convincing’

Federal Reserve Governor Christopher Waller this week reiterated his skeptical view of a U.S. CBDC. “The case for adopting one is not yet convincing to me and many others,” Waller said at an event hosted by Queensland University of Technology in Brisbane, Australia. The remarks reinforce Waller’s stance that CBDC is a solution in search of a problem.

The Crypto Ledger

In addition to the FTX-Binance bombshell, here’s what else is new in crypto.

• Silk Road unravels: Department of Justice prosecutors seized nearly $3.4 billion in bitcoin from James Zhong, a Georgia property developer who allegedly scammed the defunct criminal marketplace Silk Road. Zhong pleaded guilty to wire fraud last week, according to Bloomberg. The seizure was part of a federal investigation into missing crypto connected with Silk Road, whose founder is currently serving life in prison.
• IRS on the lookout: The IRS is building “hundreds” of crypto cases, and some of them will soon be public, senior agency official Jim Lee said in a recent Bloomberg Tax interview. Some cases involve “off-ramping” transactions, in which digital assets are exchanged for fiat currency. Others involve people failing to report crypto income, according to the article.

In Case You Missed It

What’s in the Interagency Staff Report on Treasury Markets—and What’s Been Left Out

A new interagency staff report from the Treasury Department, the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the Securities and Exchange Commission and the Commodity Futures Trading Commission noted progress on measures to strengthen the Treasury market’s resilience. The report includes steps being considered to increase the resilience of Treasury market intermediation, including an SEC dealer registration proposal, a study of the benefits and costs of broadening participation in the Treasury market to more parties (referred to as all-to-all trading), and potential changes to margin requirements. It also notes the importance of obtaining better market data through additional data collection proposals and discusses enhanced trading venue oversight, among other items.

• Elephant in the room: Policymakers are studying how Treasury market structure affects intermediation capacity, as noted in the report. But the report does not mention one of the most significant factors in Treasury market liquidity:  constraints on banks’ capacity to make markets in Treasuries arising from leverage requirements and other banking regulations. As volatility looms in the world’s most crucial bond market, those regulations need to be reevaluated.

Treasury Market Liquidity, Stablecoins: What’s in the Fed’s Financial Stability Report

The Federal Reserve’s recent Financial Stability Report highlights several potential risks to the financial system. Here are some key takeaways.

• Top of mind: Persistent inflation and monetary tightening; geopolitical conflicts such as Russia-Ukraine and China-Taiwan; market liquidity strains and under-regulated nonbanks featured among the most-cited potential risks in a fall 2022 survey of market contacts. That list of top concerns compares to a spring 2022 survey that cited COVID variants, cryptocurrencies/stablecoins and cyberattacks among the most prominent near-term worries, although the lists maintained several items in common, such as inflation and Russia’s invasion of Ukraine. The overall report noted cyber risk as a key potential threat to the financial system.
• Bank strength: The report noted that banks remain resilient even if faced with a severe downturn, as demonstrated by the stress tests.
• Stablecoins: Stablecoins are vulnerable to runs and liquidity risks, the report noted. “Some stablecoins have structural vulnerabilities that mirror those of cash-like vehicles that engage in liquidity transformation and hold risky assets, like certain MMFs,” the report said. While stablecoins’ holdings of risky assets such as commercial paper have reportedly decreased, lack of transparency around their asset holdings “could exacerbate the effects of their vulnerabilities on financial stability through spillovers to other cash-management vehicles that participate in these markets.”
• Treasury market: The report also flags liquidity strains in the crucial Treasury market. Noticeably absent was any mention of regulatory causes of Treasury market illiquidity.

BoE’s Breeden Warns of Nonbank Leverage Risks in Wake of UK Pensions Turmoil

Sarah Breeden, executive director for financial stability strategy and risk at the Bank of England, cautioned in a recent speech against leverage in the nonbank sector and its potential threat to the financial system’s stability. Nonbank leverage could spark contagion in markets and among counterparties, potentially leading to systemic risk, Breeden said. The speech came after recent instability in the UK pension sector elicited Bank of England intervention.

• Call to action: She called on banks to require enhanced transparency of hidden leverage taken by their counterparties, and to “improve their stress testing to include better understanding of market dynamics and structural shifts that might change correlations and norms.” She added that “[b]anks need to develop a laser like focus on wrong-way risk, where the value of collateral held as security falls in the very situation where the counterparty defaults. And to consider if attempts to realise collateral might further add to negative price dynamics.”
• Supervisors’ role: Bank supervisors can blunt the systemic impact of risks from nonbank leverage by strengthening risk management practices of dealer banks and prime brokers, Breeden said. “My supervisory colleagues are indeed taking steps to ensure this,” she said.

Twitter Takes Steps Toward Entering Payments Business

Twitter has filed paperwork with FinCEN to enter the payments business, according to the New York Times this week, marking another pivot under new owner Elon Musk. The NYT article suggests the registration could demonstrate a step toward turning Twitter into an “everything app” like China’s WeChat. It would also align with Musk’s history as a cofounder of PayPal.

• Regulatory view: It’s unclear how far Twitter will proceed with any payments ambitions; some of Musk’s envisioned changes to the platform have already been reversed. But federal regulators, particularly the CFPB, have their eyes on Big Tech’s role in payments. The CFPB has sought information on Big Tech platforms in the payments space, such as Google and Apple.

Regions Expands Financial Inclusion Through ATM Agreement With MDIs, CDFIs

Regions Bank this week announced an agreement with seven CDFIs and MDIs that will enable their customers to use Regions ATMs without out-of-network fees. The agreement includes Carver State Bank in Georgia, Citizens Savings Bank & Trust in Tennessee and Commonwealth National Bank in Alabama, among others.