BPInsights: November 18, 2023

Basel Costs Front and Center on Capitol Hill

The high price of higher capital requirements raised bipartisan concerns on Capitol Hill this week as top banking regulators – the Federal Reserve’s Michael Barr, OCC Acting Comptroller Michael Hsu, FDIC Chairman Martin Gruenberg and NCUA chief Todd Harper — convened for regular oversight hearings. The hearing gave lawmakers a public opportunity to question Barr in particular on the potential costs of the Basel capital proposal and the dearth of analysis underpinning it. From mortgages to small business loans, the proposal would subject consumers to higher costs and limit their access to credit, lawmakers from both parties emphasized. While Vice Chair Barr claimed the proposal would mostly affect trading and “non-lending” activities, Main Street impacts have alarmed members of Congress.

  • Universal tax: The operational risk charge in the Basel proposal, a broad tax on banking services, would affect business lines such as banks making home mortgages and selling them to the GSEs, as flagged by Rep. Gregory Meeks (D-NY) at the House hearing. Sen. Katie Britt (R-AL) noted that the proposal assumes banks are significantly undercapitalized for operational risk, “yet cites no evidence to support this assumption.” Operational risk is already captured by the stress tests and the Basel proposal’s operational risk charge is not tailored to banks’ varying business models, Britt noted.
  • Lack of analysis: Lawmakers highlighted the lack of supporting analysis for the Basel proposal and flaws in the rulemaking process. Rep. Jim Himes (D-CT) drew a contrast between Vice Chair Barr’s opening statement that the banking system is resilient, and the assumption that banks need more capital. He asked Barr to “give us a sense for how we can have confidence that that academic literature also supports the case for additional capital.” Sen. Britt pressed Vice Chair Barr on how long Fed Board members had to review the proposal before it was issued for comments, after Fed Governor Lisa Cook testified two weeks before the open meeting in July that she had not seen the proposal. Sen. Thom Tillis (R-NC) pressed for more details on the “broad consensus” Vice Chair Barr is seeking on the rule. House Financial Services Committee Chairman Patrick McHenry (R-NC) said that “it seems like these proposals we’re seeing for bank capital are about policy preferences, not driven by economic analysis. That’s concerning.”
  • ‘Perfect storm’: Sen. Mark Warner (D-VA) depicted a “perfect storm” of economic factors such as high interest rates and quantitative tightening that could push lending outside of the regulatory perimeter.
  • Small business: Vice Chair Barr downplayed the impact on mom-and-pop customers in his testimony, saying at the House hearing that “The rule that we have proposed would not make significant changes with respect to the cost of credit for small businesses.” (This statement is not consistent with economic research demonstrating that businesses could face much higher costs for loans.) Sen. Jon Tester (D-MT) and Rep. Roger Williams (R-TX) expressed concerns about the proposal’s effects on small businesses’ access to credit.
  • Intertwined rules: Another concern about Basel is the combined impact of simultaneous bank rulemakings, such as a revised Community Reinvestment Act rule, a long-term debt proposal, a CFPB proposal on credit card late fees. Regulators must consider the cumulative effects of all these proposals on the banking system and consumers, lawmakers led by Rep. Bill Huizenga (R-MI) urged in a letter this week. Rep. Gregory Meeks (D-NY) questioned Acting Comptroller Hsu about the interaction between the revised CRA rule and the capital proposal. Sen. Britt also called for regulators to examine the cumulative impact of their measures. “We have to look at how these things work together because it is clear that there is a trickle-down effect,” she said.

Five Key Things

1. Internal Models Should Be Allowed for Credit Capital Requirements

The banking agencies’ Basel proposal would ban banks in the U.S. from using their own models as inputs to determine credit risk capital requirements. A new BPI analysis explains why that is an unjustified approach.

  • Deviation: The internal models ban is a deviation from the international Basel standard. The U.S. regulators contend that banks’ internal credit models result in “unwarranted” differences in credit risk capital requirements among banks because the models may rely on subjective assumptions.
  • Unsupported: The Basel proposal cites two studies to support the view that bank internal models have produced “unwarranted” variability in bank credit capital requirements. But neither of these analyses actually support the idea that the variability is unwarranted.
  • Ignoring the caveats: The proposal disregards the important caveats in the two studies it cites to justify its objections to bank internal models. One caveat: differences in variability can be misleading – analyses can identify differences in risk-weighted assets but may not be able to pinpoint whether they correspond to differences in underlying risk. It is also difficult to disentangle differences in risk from other factors when explaining variability: for example, differences in the effectiveness of a bank’s risk management department could explain some variability.
  • Not so simple: Reasons for variability from internal models are not as simple as the proposal suggests. They can involve differences in supervisory practices, discretion in the definition of “default”, and model validation rules that encourage conservative estimates.
  • U.S. bank focus: The proposal fails to mention two recent studies that focus on variability of probability-of-default and loss-given-default modeling among large U.S. banks. This research seems highly relevant to the proposal, and it shows that the proposal may be exaggerating the problem of probability-of-default variability for corporates.
  • Putting gaming concern to rest: Overall, the academic evidence does not establish that banks in general, much less U.S. banks, have systematically gamed the internal model framework by underestimating credit risk. This is not a surprising result given the robust regulatory supervision of U.S. banks.
  • The hidden costs of one-size-fits-all: The agencies are aiming to rely on a standardized approach for credit risk that requires minimal regulatory supervision. Such a one-size-fits-all approach would come with long-term hidden costs, such as lowering banks’ incentives to invest in effective credit risk management.  

2. Basel Endgame Will Drive Up Costs for Farmers, Consumers

The Basel Endgame proposal will raise costs for American farmers and consumers, warned Sen. Jerry Moran (R-KS) in a recent American Banker op-ed. “The proposals inadvertently harm both producers and consumers by raising the cost to responsibly hedge against risk,” Moran wrote. The Basel proposal will threaten access to hedging tools and ultimately drive costs higher for farmers hedging the risk of commodity price fluctuations by making it costlier for banks to centrally clear derivatives, he said.

3. WSJ Investigation Depicts Toxic Work Environment at FDIC

The Wall Street Journal this week published investigative pieces describing a toxic workplace at the FDIC. The initial article detailed allegations of pervasive sexual harassment and misconduct that allegedly drove away female bank examiners, with the accused perpetrators remaining employed at the agency. A follow-up piece reported that Chairman Martin Gruenberg had angry outbursts toward colleagues that led to an inquiry, and that he and former Chairman Sheila Bair tolerated or dismissed inappropriate behavior in the workplace.

  • FDIC response: Gruenberg fielded scrutiny and criticism from multiple lawmakers about the allegations at this week’s prudential regulator hearings. The FDIC said it has hired an outside law firm to probe the subject. 
  • Investigations: FDIC Board members Travis Hill and Jonathan McKernan said in a statement that the investigation into the misconduct must “be effectively overseen by the Board and have the latitude and time needed to conduct a thorough, holistic review.” They also said “The Board should be appropriately informed throughout the review process.” House Financial Services Committee Republicans on Friday said they were probing the FDIC over the issues. In addition, Senate Banking Committee Democrats on Friday called for an independent investigation.

4. FDIC Approves Special Assessment on Large Banks 

The FDIC late Thursday approved a special assessment on banks to recoup costs to the Deposit Insurance Fund associated with invoking the systemic risk exception during the bank failures in March. The agency voted 3-2 on the measure in a so-called notational vote after canceling its scheduled open meeting amid controversy over a Wall Street Journal report on FDIC workplace culture. The brunt of the assessment will apply to larger banks. The final rule closely resembles the original proposal, but increases the total assessment amount (from $15.8 billion to $16.3 billion). Like the proposal, the final rule assesses banks based entirely on the amount of their uninsured deposits.

  • Methodology: In response to the proposal, BPI had pointed out flaws in the FDIC’s rationale for its special assessment methodology and argued that the proposal failed to provide sufficient analysis to support this methodology. The FDIC’s rationale in the final rule, however, remains mostly unchanged.
  • Assessment Reporting Review: The FDIC also announced that it is conducting a review of banks’ reporting methodologies for uninsured deposits, which could affect how much they owe for the special assessment

5. Garbarino, Tillis Aim to Overturn SEC Cyber Rule

Rep. Andrew Garbarino (R-NY) and Sen. Thom Tillis (R-NC) each introduced measures to invalidate the SEC’s cyber disclosure rule under the Congressional Review Act, a law that allows Congress to undo federal regulations by vote. The rule constitutes SEC overreach that conflicts with Congress’ intent to harmonize federal incident reporting requirements, Garbarino said in a statement.

  • BPI’s view: “We support Congressman Garbarino and Senator Tillis’s commitment to strengthening national cybersecurity and holding regulators accountable for facilitating that goal,” BPI’s Heather Hogsett said in a statement. “Banks strongly support sharing information on cyber threats and are in ongoing contact with regulators and government agencies following an incident. We believe there are better ways to promote transparency, protect investors and mitigate contagion risk than by publicly sharing detailed vulnerability information with criminals and hostile nation states while remediation is ongoing.” 

In Case You Missed It

The Crypto Ledger

House Financial Services Committee Ranking Member Maxine Waters (D-CA) said discussions with Republican colleagues on stablecoin legislation are ongoing, according to POLITICO this week. Here’s what’s new in crypto.

  • Lawmakers call for custody clarity: A bipartisan, bicameral letter from Reps. Patrick McHenry (R-NC), French Hill (R-AR), Mike Flood (R-NE), Ritchie Torres (D-NY) and Wiley Nickel (D-NC) and Sens. Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-NY) urged regulators not to enforce the SEC’s Staff Accounting Bulletin 121, which the GAO recently deemed a “rule” in the context of the Congressional Review Act. The accounting bulletin was issued without the required Congressional input. “Enforcing this noncompliant rule would set a concerning precedent that would facilitate regulatory gamesmanship to circumvent the APA, effectively allowing the SEC to have regulatory authority over institutions which Congress did not authorize,” the lawmakers wrote.
  • Also on the Hill: At the prudential regulator hearings this week, the OCC’s Michael Hsu said his agency will host a public symposium in February on the concept of tokenization. “In contrast to crypto, tokenization is driven by solving real world settlement problems and can be developed in a safe, sound, and fair manner,” Hsu said at the House hearing.

How Higher Capital Requirements Favor Government Over Business Growth

Raising bank capital requirements leaves less room for innovation and dynamism in the economy, former World Bank chief David Malpass wrote in a Wall Street Journal op-ed this week. Here’s a key quote:

“[T]he Fed must allow capital to flow more freely for greater investment and dynamism. The Fed controls banks by setting requirements on risk-based capital, leverage and liquidity. The current mix is choking off innovation and small-business lending, compounding the crowding out from the Fed’s giant bank debt. Government regulators have made repeated mistakes, among them putting costly capital requirements on business loans but none on government, biasing capital to government. Regulators understated the risk of an interest-rate spike in stress testing and ignored the maturity mismatch and withdrawal risk at Silicon Valley Bank and others. Regulators blame banks when mistakes occur. The medicine—higher capital requirements—drives up costs and lowers growth more than it lowers risk.”

Fifth Third Exceeds $180M Commitment to Empowering Black Futures Neighborhood Program

Fifth Third Bank this week announced it has exceeded its commitment of $180 million over three years for its Empowering Black Futures Neighborhood Program. The program has invested $187 million in two years in nine low- to moderate-income neighborhoods. Community Impact Report.

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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.