BPInsights: October 1, 2022

Stories Driving the Week

Is Climate Really a Financial Stability Risk or Solvency Risk for Large Banks?

To meet the needs of the global carbon transition, banks are building risk management capabilities and committing to Paris Agreement goals. But the economic risks of the low-carbon transition and the physical risks of severe weather events do not necessarily translate into financial stability risks or safety and soundness risks for large banks, a new BPI post noted. Evidence suggests that banks are well-positioned to withstand climate-related financial risks – yet global regulators are imposing intensive, detailed requirements on banks that are disproportionate to the actual climate-related risk they face.

Context: In recent years, regulatory officials across the globe have proposed climate risk management measures, released climate scenario analysis exercises and unveiled disclosure requirements. This flurry of regulatory and supervisory activity appears to be out of step with the level of material climate-related risk to large banks’ balance sheets. Climate risk should be understood and carefully managed but does not seem to represent a meaningful risk to large banks’ balance sheets.

The evidence: Several studies suggest banks could handle climate effects – either physical risks, like floods and wildfires, or transition risks, like a carbon tax – without sustaining major losses. The studies include a New York Fed staff study from January 2022, which found that FEMA disasters over the last century had “insignificant or small effects on bank performance and stability,” and an FDIC staff study from June 2022 that found no evidence of bank distress resulting from severe weather events and little evidence of a deterioration in loan performance. In addition, while climate scenario analysis is an evolving tool with limited precision in its results, the exercises have not resulted in huge near-term losses for banks. On transition risk, the results of climate stress tests suggest similar resilience: even losses under severe transition scenarios are much smaller than losses projected in regular stress tests, suggesting large banks have the wherewithal to handle transition risks.

Worth noting: Climate risk analysis for banks should also be informed by how markets and bank balance sheets work. For example, regulators can take lessons from “creative destruction,” in which changing conditions or technological advances lead to some industries falling and others rising. The phenomenon – as seen among department stores and Kodak — tends to cause firms in the declining industry to gradually shrink or be bought by other firms, rather than catastrophic failures or losses. In addition, the short-dated nature of many bank loans to potentially affected businesses can enable the financial system to adjust to gradual change.

Bottom line: Recent studies and regulatory tests demonstrate that climate risk is not a material threat to large banks and should not have direct implications for the bank capital framework.

Relatedly: The Federal Reserve on Thursday announced that six large banks will participate in a “pilot climate scenario analysis exercise” that will launch in early 2023 and likely conclude around the end of the year. The Fed noted that there will be no capital or supervisory implications from the pilot. The six participating banks are Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Wells Fargo.

Fed, FDIC Plan to Issue Guidance on Large Regional Banks’ Living Wills

The Fed and FDIC on Friday announced they plan to issue new guidance soon for large regional bank resolution plans, or “living wills.” The guidance will apply to banks with more than $250 billion in total assets that are not GSIBs. The agencies will seek public comment before finalizing the guidance. This forthcoming guidance could address concerns raised earlier this year by OCC Acting Comptroller Hsu about large regional bank resolvability and the potential need for certain resolution enhancements, including possibly additional loss absorbency requirements.  Resolution plan feedback issued to one large regional bank in connection with the announcement provides a preview of the guidance to come, indicating that it will focus on the practical feasibility of a bridge bank strategy and the liquidity needs of material subsidiaries, including nonbank affiliates.  BPI has previously opined on whether potential adjustments are necessary or appropriate; see herehere and here.

FRB Governor Miki Bowman Opines on Large Bank Supervision

The resiliency of large banks has been “repeatedly confirmed by both supervisory and real-life stress tests,” Federal Reserve Governor Michelle Bowman observed in a speech Friday in which she offered her views on a wide range of large bank supervision topics.  Her comments come as Vice Chair for Supervision Michael Barr is planning a review of the capital framework for large banks. Here are some key takeaways.

  • Forward look: Banks’ record of success in recent years argues for maintaining an incremental, carefully calibrated approach to changes in supervision and regulation, Bowman said.
  • Stress testing: Bowman noted variability in the stress test results from year to year, “due to how a specific scenario interacts with a specific firm’s business model.” She said “this volatility flows through to the stress capital buffers that apply to the largest firms.” Such variations “are often not based in underlying changes to banks’ business models” and can create challenges for capital management, she observed. “There are likely many ways to limit this volatility while maintaining the value of the Board’s stress tests, including by averaging results over multiple years.”
  • Holistic review of the capital framework: Capital should be considered holistically, Bowman said, and it is not a “zero-sum game, where more capital is necessarily always better.” She noted that “over-regulation” can constrain bank lending and hold back economic growth. Leverage ratios that discourage banks from intermediating in the Treasury market or holding Treasuries and reserves can “distort incentives and disrupt markets,” she said. “Addressing these issues could improve market functioning and financial stability.” On the countercyclical capital buffer, she said: “Balancing safety and soundness with the need for appropriate risk-taking means that we should not simply assume that the further layering on of capital requirements, including through the application of the CCyB, would be beneficial.”
  • M&A: Bowman called for transparency in timelines and expectations for the bank merger review process. “The rules of the road should not change during the application process,” she said. Policymakers should ensure that “other factors, like the idea that mergers are harmful or that increased bank size is inherently problematic, do not infiltrate that statutory analytical framework.” For large banks in particular, the merger review framework should factor in “the evolution of markets, industry, and customer preferences.”
  • Resolution: Bowman emphasized the need for fairness and due process in bank resolution planning, particularly for regional bank resolvability. She noted a debate about single point of entry resolution for regional banks. Policy actions in this area will require working with other banking agencies and seeking public comment, she said. “Fairness dictates that this debate occurs in the arena of regulation, with all the appropriate due process protections that this entails, and not on an ad hoc basis for a single firm that chooses to make an acquisition subject to regulatory approval,” she said.

For digital assets, Bowman also suggested policymakers “consider whether there is a stabilizing role for banks to play in intermediation, or ensure that the competitive landscape does not create a financial stability risk by pushing activities outside the banking system, as we have seen with the mortgage industry.” Any clarity regulators provide should recognize that crypto-assets have risks, but “we should allow banks to participate as long as the risks can be identified and managed appropriately and responsibly.” She also called for improving transparency around bank supervisory standards.

Treasury Finalizes Beneficial Ownership Rule 

The Treasury Department this week finalized its beneficial ownership rule, taking a major step in implementing the comprehensive anti-money laundering reforms enacted in the Anti-Money Laundering Act of 2020. The rule requires companies to report their beneficial owners to the U.S. government in order to root out anonymous shell companies that enable criminals to hide assets and launder money.

Trades Sue CFPB Over Exam Manual Change

The U.S. Chamber of Commerce, American Bankers Association, Consumer Bankers Association and several other trade associations filed a lawsuit against the CFPB opposing the Bureau’s exam manual change that expands the agency’s ability to pursue discrimination claims against financial firms as an ”unfair” practice under the agency’s UDAAP authority. The trades assert that the CFPB is exceeding its statutory authority and that the updated exam manual violates the Administrative Procedure Act and is arbitrary and capricious.  The lawsuit was filed in federal court in Texas.

BPI Supports Senate Effort to Achieve Digital ID Benefits

The U.S. Senate Homeland Security and Governmental Affairs Committee voted to pass the “Improving Digital Identity Act of 2022” (S.4528) during a legislative markup this week. The bill would establish a federal task force to identify a digital ID implementation strategy across federal, state and local governments in a way that is user friendly, accessible, enhances security and preserves privacy. The task force would also coordinate an intragovernmental effort to ensure that digital IDs remain interoperable with existing physical ID, such as a driver’s license or passport.

“We support this legislation and believe a well-constructed digital ID would improve security and enhance customer convenience,” stated Ed Hill, head of government affairs at the Bank Policy Institute. “We are grateful to Sens. Kyrsten Sinema, Cynthia Lummis and Rob Portman and Reps. Bill Foster, John Katko and Carolyn Maloney for spearheading this effort in Congress. It is also worth highlighting the substantial contributions of the Better Identity Coalition to this issue.”

In addition to establishing the “Improving Digital Identity Task Force,” the bill requires the Government Accountability Office to submit a report to Congress indicating any potential cost savings that digital ID implementation would have on reducing fraud and instances of identity theft.

The bill now advances to the full Senate for consideration.

Powell Calls for Crypto Regulation, Stresses Deliberate Pace on CBDC

Federal Reserve Chair Jerome Powell called for crypto regulation at a recent conference hosted by the Banque de France. While the DeFi ecosystem is not currently intertwined with the traditional financial system in problematic ways, “that situation will not persist indefinitely,” Powell said, according to Bloomberg. Regulation is necessary to protect consumers, he said. Powell also reiterated the central bank’s deliberate approach to a potential U.S. CBDC. “At the end of the day, we will need approval from both the executive branch and Congress to move ahead with a central bank digital currency,” he said. “So, we see this as a process of at least a couple of years, where we’re doing work and building public confidence in our analysis and in our ultimate conclusions, which as I say, we certainly haven’t reached yet.”

Brainard Warns of Potential Shocks Amid Tightening Process

Federal Reserve Vice Chair Lael Brainard said the central bank is watching for potential financial vulnerabilities as global central banks tighten monetary policy to combat inflation. “It is important to consider how cross-border spillovers and spillbacks might interact with financial vulnerabilities,” Brainard said in a speech Friday. She noted that “nearly all of the jurisdictions that built countercyclical capital buffers before the pandemic released those buffers at the outset of the pandemic, and the buffers have not been fully replenished so far.” Brainard cited an ECB analysis concluding that “the release of capital buffers increased headroom for banks relative to not only their regulatory thresholds, but also their internal risk controls, and enabled banks to continue providing credit to households and businesses.”

In Case You Missed It

Bowman: Banking Has Changed. Maybe Competition Analysis Should, Too

Federal Reserve Governor Michelle Bowman in a recent speech suggested several updates to bank competition analysis to reflect a banking marketplace that has undergone major changes in recent years. Any modernization proposal for bank competitive analysis in connection with a bank M&A application should incorporate competition from credit unions and nonbank financial firms and the presence of digital banking, Bowman said. One way to capture the competitive effects of nonbank firms is by “relaxing the deposit-market-based HHI thresholds in the current bank merger guidelines to reflect the increased competitive influence banks face from nonbanks today,” Bowman said, referring to the Herfindahl-Hirschman Index traditionally used to screen mergers. Bowman’s remarks and recommendations focused on community bank issues, but “the framework for analyzing bank mergers for large banks also needs to be updated,” she said. The comments come as the Justice Department and banking agencies are considering potential changes to bank merger review standards.

In Emergency Step, Bank of England Intervenes in UK Bond Market

The Bank of England this week took emergency action to buy bonds in order to avert a crisis in government-debt markets that could roil British pensions. The Bank framed the bond-buying effort as “temporary” and “strictly time limited.” “Were dysfunction in this market to continue or worsen, there would be a material risk to UK financial stability,” the BoE said in a press release. The central bank pledged to buy long-dated bonds at a rate of up to £5bn a day for the next 13 weekdays. The move comes as the Bank has been trying to fight high inflation.

FT: Citi to Scale Back Private Equity Lending in Sign of Capital Requirements’ Hit

Citigroup plans to significantly curtail subscription-line financing – a form of lending geared toward private equity groups – as a result of an increase in capital requirements via the Fed’s stress tests and in a sign that those are constraining large banks’ lending capacity. Citi plans to slash its subscription-line financing book from about $65 billion to $20 billion in the coming months, the Financial Times reported recently.

The Crypto Ledger

Client demand for crypto as a payment method has dropped dramatically over the last six months, according to a recent interview with JPMorgan Chase’s global head of payments. Here’s what’s new in crypto.

  • Stablecoin bill: House stablecoin bill discussions hit roadblocks that may be holding lawmakers back from marking up any bill text in committee, according to POLITICO. Both Democrats and Republicans have expressed concerns as the legislation takes shape. Democrats raised objections that the draft bill text failed to address AML rules and could pose new financial system risks through its reserve requirements, according to the article, which also cites disagreements about the role of state financial regulators. Sen. Pat Toomey (R-PA), ranking member on the Senate Banking Committee, has also raised concerns about how the Fed would regulate stablecoin issuers if it introduces a CBDC.
  • Run risk? The founder behind the collapsed Terra stablecoin, Do Kwon, faces an arrest warrant issued by South Korean authorities – but Kwon claims he is “not ‘on the run’”. His firm, Terraform Labs, accused South Korean prosecutors of overreaching.
  • California veto: California Gov. Gavin Newsom recently vetoed a digital assets bill that would require crypto financial-services businesses to get a license to operate. Newsom called the legislation “premature.”
  • FTX’s winning bid: FTX won an auction for bankrupt crypto broker and lender Voyager Digital’s assets.
  • Custodia in court: A group of Republican lawmakers filed an amicus brief in support of Custodia, the Wyoming crypto firm seeking access to a Federal Reserve master account. Custodia has sued the Kansas City Fed and the Federal Reserve Board over alleged delays on the account access decision. The lawmakers contended that the Fed had exceeded its one-year deadline to decide on Custodia’s application and that Custodia, a state chartered special purpose depository institution, is a depository institution under the Federal Reserve Act and, as such, the Fed has no discretion and must grant Custodia a Fed master account.

BPI’s Erik Rust Promoted to Deputy Head of Government Affairs

BPI’s Erik Rust has been promoted to a new role as senior vice president and deputy head of government affairs. Before joining BPI in 2020, Rust was a director for the Center for Capital Markets Competitiveness at the U.S. Chamber of Commerce and is a House alum.

Gooden-Welch Bill Prioritizes Big Box Retailers over Consumers

American Bankers Association, Bank Policy Institute, Consumer Bankers Association, Credit Union National Association, Electronic Payments Coalition, Independent Community Bankers of America, and National Association of Federally-Insured Credit Unions sent a letter this week to House Speaker Nancy Pelosi and Minority Leader Kevin McCarthy warning the interchange bill introduced by Reps. Lance Gooden (R-TX) and Peter Welch (D-VT) would reduce access to credit, increase security risks associated with credit card use, and limit credit card rewards programs. The eight leading financial services trade associations issued the following joint statement

“Quite simply, credit cards make life work. Consumers have come to rely on their credit card of choice to pay for gas, groceries, and unexpected emergencies. This is especially true as consumers leverage their credit card rewards to deal with rising costs.

“It’s disappointing that the Gooden-Welch bill prioritizes big box retailers’ profits over consumers at a time when consumers can least afford it. The Gooden-Welch bill would allow merchants to choose the cheapest routing networks – which may not offer the same robust security as trusted, established payment networks. This creates additional risks for financial services providers that are extending credit to consumers for everyday purchases, big and small. 

“That’s an important distinction that retailers are trying to overlook; financial institutions cover the costs for replacement cards and fraudulent purchases, making them more sensitive to changes in the payments system than merchants.

“We are particularly concerned that changes to the current routing system would disproportionately harm credit unions and community banks that serve underbanked areas. We’ve witnessed how the 2010 Durbin Amendment, which was adopted as part of the Dodd-Frank Act, capped debit card fees, leading to a decrease in free checking accounts and low-cost banking services for consumers. We are determined not to repeat the past – and, as such, we oppose the Gooden-Welch bill.”

HSBC Invests in Tech to Help Immigrants’ Credit Scores Cross Borders

HSBC has invested in and partnered with a fintech company, Nova Credit, to help the bank access credit scores and reports from other countries and enable access to credit for immigrants.

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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.