BPInsights: November 4, 2023

Basel’s Universal Tax on Every Bank Borrower and Intermediation Activity

The operational risk charge drives 90 percent of the increase in capital requirements from the Basel proposal. A note published this week by BPI shows the proposal dramatically overstates banks’ operational risk, and it has real costs: It would raise borrowing costs for consumers and businesses, result in less competition and shift more financial intermediation to nonbanks. The overcapitalization layers a broad, unnecessary tax on every bank activity, from credit cards to loans to helping companies issue stocks and bonds.

Stepping back: Operational risk is the risk of losses resulting from a major disruption like a cyber attack, fraud, or lawsuits. Policymakers often point to cyber attacks as the most significant operational risk for banks, but banks’ largest losses have, in fact, come from government fines, penalties, and related legal expenses.

Capital requirements for banks should be evidence-based, and the data exists: The Basel proposal assumes banks are undercapitalized for operational risk, but cite no evidence to support that assumption. A new BPI analysis shows that the combination of both the new standardized approach for operational risk and the stress test capital charge would result in a substantial overstatement of capital requirements for the actual risks banks face.

  • Diving deep: Using a recent analysis published by  ORX, the largest operational risk management association in financial services, U.S. banks’ op-risk losses rarely exceed 30 percent of the capital required under the new proposal over the past 20 years.
  • Unjustified assumption: The proposal assumes that extreme losses in credit, market, operational risk and derivatives would all occur simultaneously – with a correlation of 1. This scenario is extremely unlikely and therefore overstates the capital requirement.

Redundant: Banks are already required to hold operational risk capital through the Fed’s stress test. This charge would combine with the Basel operational risk requirement to impose overall capital requirements 5x larger than almost all of the largest losses incurred by U.S. banks in the worst year since 2003.

Blunt instrument: The operational risk charge in the Basel proposal is not tailored to U.S. banks’ business models and is particularly punitive on banks with fee-income businesses, such as the issuance and usage of credit cards, sale and servicing of mortgage loans, syndicated lending, revenue from operating leases on auto loans, custodial services, and advisory services.

Even leaving aside the duplicative stress test charge and the flawed correlation assumption, the proposal’s charge for operational risk is an overstatement. And its economic implications are huge. Using the same methodology as the one employed by the Basel Committee, the operational risk requirement would diminish U.S. GDP by close to $90 billion each year.

  • Self-inflicted wound: This American Banker op-ed authored by BPI’s Greg Baer and Francisco Covas explains the problems with the operational risk part of the Basel proposal. “There is no reason to believe that operational risk justifies this self-inflicted wound to our country’s economic growth,” the op-ed states.

Five Key Things

1. Powell Expects Revised Basel III Endgame Proposal to Elicit Broad Support on the Board

Federal Reserve Chair Jerome Powell expects the final Basel III proposal to be revised in response to comments and ultimately have broad support by the Board when it comes to a vote. In response to a question at the post-FOMC meeting press conference this week on if he would accept finalizing the proposal without significant changes, Powell stated that the Fed will take comments on the Basel proposal seriously and will “come to a package that has broad support on the Board.” When pressed by the reporter, “Does broad support mean more support than the proposal had?”, Powell responded that “it means broad support.”

2. Lawmakers Press Regulators for Clearer Bank M&A Path

Reps. Andy Barr (R-KY) and Scott Fitzgerald (R-WI) called on the banking agencies to provide “greater clarity and timeliness in the merger and acquisition review process for banking organizations.” In a recent letter, they expressed concern about bank M&A applications languishing under delays with little transparency. Federal policymakers have been considering changes to the bank M&A review process but have not put proposed revisions out for notice and comment, Barr and Fitzgerald observed. “Clear expectations and timelines surrounding the review process are critical so banks can make an informed decision as to whether to continue devoting resources and incurring costs when approval is likely or withdraw an application and reduce expenses when it is not,” the lawmakers wrote. They noted that a transparent, timely and efficient merger review and approval process promotes competition in the banking system, and the economies of scale that arise from bank mergers bring benefits to consumers. The representatives also requested that the regulators respond with any plans, regulatory proposals or proposals for legislation that would provide greater clarity in the M&A process.

3. SEC Must Fix Problems with Buyback Rule, Court Says

A federal court ruled this week that the SEC must fix procedural deficiencies in its rule that would require more detailed disclosure from companies about stock buybacks. A three-judge panel of the U.S. Court of Appeals for the Fifth Circuit gave the SEC 30 days to remedy defects in the rule. The decision came in response to a challenge from the U.S. Chamber of Commerce and two Texas-based trade groups. The SEC failed to consider stakeholder comments on the proposed rule, including comments that empirically challenged the underlying premise for the rulemaking, and adequately substantiate the rule’s costs and benefits, the court ruled.

4. GAO: SEC Erred by Not Submitting SAB 121 for Congressional Review  

The GAO determined that the SEC’s Staff Accounting Bulletin No. 121, known as SAB 121, is a rule subject to Congressional scrutiny. According to the GAO, SAB 121 meets the definition of a rule under both the APA and the Congressional Review Act, and therefore the SEC should have submitted it to Congress for review under the CRA, which the SEC did not. Under the Act, Congress is authorized to review and potentially vote to invalidate an agency rule, and no rule may take effect unless and until it is properly submitted to Congress.  SAB 121, which describes how public companies should account for custodial activities related to crypto assets, significantly affects banks with custody businesses because it mandates that firms undertaking crypto asset custody services should record a liability and corresponding asset on their balance sheets.  This in turn triggers capital requirements for banks that make offering these custody services financially infeasible. Nonbanks are not similarly affected.

  • SEC response: “The GAO opinion expresses its view that SAB 121 is a ‘rule’ for purposes of the CRA,” the SEC said in a statement published by CoinDesk. “The opinion does not otherwise affect the status of SAB 121.”  This suggests the SEC does not view SAB 121 as ineffective.  It’s unclear whether other federal agencies, including the federal banking regulators, will take the same view.
  • Implications: The GAO’s decision, along with the SEC’s response, raises questions about the legality of the SEC’s bulletin and whether agencies face any real consequences if they fail to comply with the Act.  Going forward, Congress may choose to evaluate whether the Act needs more teeth.

5. What’s Ahead for CRA? Fed’s Barr Weighs In

After the banking agencies finalized their revised Community Reinvestment Act rule last week, Federal Reserve Vice Chair for Supervision Michael Barr offered insights on the rule and next steps for banks, supervisors and communities. Barr participated in a Q&A with the National Housing Conference’s David Dworkin on Friday at a CRA event.

  • Qualitative: The rule provides clear metrics, Barr said, but there is also a need for “qualitative judgments” by examiners to determine whether activities are benefiting communities, he said.
  • Certainty: It’s important for banks to have certainty on what qualifies for CRA credit, Barr said. Uncertainty on that front was a problem under the previous rule. There will now be a process in which banks can take projects to regulators for validation on CRA qualification, Barr said.
  • Engines for community investment: Barr highlighted several programs, such as special-purpose credit programs, low-income housing tax credit and partnerships between banks and CDFIs and MDIs, that can promote community development.
  • ‘Durable’: Barr expressed confidence that the rule would be “durable” and lasting, but also able to adjust and be flexible as the financial sector adjusts. He said the rule took into account stakeholder feedback and that it underwent many changes since the initial proposal.
  • Getting ready: Barr said the two-year implementation period will enable banks, communities and regulators time to prepare. He highlighted examiner training and procedure manuals and the need for community engagement.
  • Raising alarms: The Basel capital proposal could hurt lenders’ efforts to extend credit to underserved communities, Lisa Rice, president and CEO of the National Fair Housing Alliance, said at the same CRA event. “The proposed capital rule for example, I could see it literally squashing any efforts by lenders to stand up special purpose credit programs,” Rice said. She said the regulators worked on the capital proposal “sort of in a silo” rather than communicating with other divisions in the regulatory agencies to understand effects of the proposal.
  • Bottom line: Given the importance of banks’ CRA programs, they continue to review the rule, which clocks in at over 1,400 pages, to understand its implications for their ability to serve low- and moderate-income communities and individuals. 

In Case You Missed It

American Banker: Banks ‘Flying Blind’ Without Big-Picture Data on Overlapping Rule Changes

The cumulative impact of multiple overlapping bank regulatory proposals is unclear in the absence of analysis from the regulators, American Banker reported this week. The Basel capital proposal, long-term debt proposal and the CRA final rule will have significant impacts on the banking system, yet the regulators have not conducted a big-picture analysis of their cumulative effects, and the lack of such analysis could lead to unintended consequences. This analysis is the duty of the agencies, which have access to the type of confidential, comprehensive data sets required to conduct it. “The number one challenge is resourcing and data,” said BPI’s Francisco Covas in the article. “We would need to have a broad set of data — most of which is confidential — and we would need it from a long period of time, which the Fed already collects. To get all that data and all the proper agreements in place, by that time the comment period would be closed and we’d have a final rule.”

The Crypto Ledger

FTX founder Sam Bankman-Fried was convicted this week of seven counts of fraud. Here’s what else is new in crypto.

  • PayPal: PayPal disclosed this week that it has received a subpoena on its stablecoin work from the SEC’s enforcement division. The company said it is cooperating with the request.

Redundant Reporting Stresses Banks’ Cybersecurity Readiness, Warrants White House Review

BPI and the American Bankers Association this week made recommendations to the Office of the National Cyber Director in response to its effort to harmonize cyber regulations under the National Cybersecurity Strategy. Unlike other industries, financial institutions are subject to multiple regulators exercising authority on a litany of complex and overlapping regulations. The letter summarizes these existing obligations and recommends a balanced approach to compliance that would help cybersecurity professionals focus on their critical operational responsibilities.

Overlapping and redundant compliance requirements divert resources that could otherwise be used to protect against future threats,” the groups stated. “Greater coordination among all financial regulators and with industry are prerequisites to a more secure sector, and the optimal way to get there is to assess existing requirements and unify around common goals and standards creating a more streamlined and efficient regulatory process.”

To learn more, click here.

Judge: Federal Reserve Banks Don’t Owe Firms a Master Account

A federal district court judge denied a motion from a Puerto Rico-based bank seeking to preserve its master account with the Federal Reserve Bank of New York. The New York Fed had closed Banco San Juan Internacional’s master account over money laundering and Bank Secrecy Act concerns. The judge, John Koeltl of the U.S. District Court for the Southern District of New York, rejected the bank’s notion that the New York Fed violated the bank’s “statutory right” to a master account. Koeltl said the Federal Reserve Act does not require the Federal Reserve banks to grant a master account to any bank – a principle with implications for other Fed challenges over master account access, such as lawsuits from Idaho’s PayServices Inc. and Wyoming’s Custodia Bank.

BofA Highlights Four Small Businesses at Bryant Park Winter Village

Bank of America recently unveiled four New York City businesses (which are women- and/or minority-owned) to be featured in the Bank of America Winter Village at Bryant Park this year. The businesses will showcase and sell their products at a rent-free booth in the village for more than two weeks each. The initiative aims to enable small local businesses to reach new customers.

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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.