BPInsights: October 21, 2023

Banking Agencies Launch Impact Study, Extend Comment Period for Basel Proposal

The federal banking agencies on Friday announced an extension of the comment period on the Basel capital proposal from Nov. 30, 2023 to Jan. 16, 2024. They also announced a quantitative impact study of the effects of the proposal with a due date of Jan. 16, 2024.BPI response: BPI issued a statement in response to the announcements. “The Federal Reserve’s announcement of the quantitative impact study and comment extension is only the beginning of resolving the significant problems with the agencies’ capital proposal, not the end. The agencies should have engaged in rigorous economic analysis of the proposal’s costs before, not during, the comment period. As a matter both of good policymaking and legal compliance, they must also give the public ample time – 120 days – to analyze and comment on the results of the impact study after they are released. The public will be bearing these costs and should be allowed enough time to evaluate and comment on them. The most appropriate solution is to re-propose the rule after publishing the results, taking a thorough cost-benefit analysis into account.” 

Background: BPI and a coalition of trades had called for a re-proposal of the rule with a new 120-day comment period due to critical omissions and legal shortcomings in the proposal. Last week, BPI and other trades urged the agencies to conduct a quantitative impact study, but emphasized that this step would be coming late and would not remedy the problems with the proposed rule. In that letter, the trades recommended that the agencies re-propose the rule after the study’s results are released, or else extend the comment period of the proposal to 120 days after that release.

Five Key Things

1. Rationalizing the Global Market Shock

The Federal Reserve’s main tool for testing the ability of banks’ trading desks to weather a market storm, the Global Market Shock (GMS), was necessary after the Global Financial Crisis, but as currently calibrated is redundant in light of the new Basel market risk standard, the Fundamental Review of the Trading Book (FRTB). The Fed now has the opportunity to repurpose the GMS by removing extreme shocks that look backwards to the Financial Crisis and replacing them with shocks that look forward to the potential risks that might not be captured by the FRTB. The first step in a GMS recalibration would be for the Fed to rationalize the GMS shocks with respect to the FRTB by using an empirically driven and objective methodology based on widely used econometric tools.

The backstory: In the wake of the Global Financial Crisis, the Federal Reserve launched a measure known as the Global Market Shock, meant to simulate intense market turmoil to test banks’ market-risk resilience. When the Fed formalized this measure as part of its Comprehensive Capital Analysis and Review stress testing process, the Basel I capital framework for market risk was in place in the U.S., and it had demonstrated shortcomings measuring market risk during the crisis. The current market risk capital standard corrected many of the problems in Basel I’s market risk framework, but it was not a perfect solution – the GMS played an important role in complementing that standard.

What’s new: Now, the banking agencies are implementing the Fundamental Review of the Trading Book, the new Basel market risk measure, which captures the same key risks as the GMS – namely, extreme market illiquidity that freezes trading activity for long periods. Using an objective statistical methodology, the Fed could rationalize the GMS by minimizing overlap with the FRTB while improving consistency with the CCAR macroeconomic assumptions, using these principles:

1. reduce the implicit GMS illiquidity horizons to be under the FRTB assumptions, in order to minimize the GMS-FRTB overlap
2. use the more realistic assumption of limited rather than no liquidity for the reduced horizons to address the CCAR scenario inconsistency

Bottom line: Recalibrating the GMS in this way should result in GMS shocks that are lower for equities by about a factor of 2, and lower for credit-default swap spreads by about a factor of 10. These changes will substantially reduce but not eliminate the overlap between the GMS and the FRTB and will make the GMS internally consistent with the CCAR macroeconomic assumptions. However, this would be only a first step – to make the GMS a fully effective complement to the FRTB, the Fed should take the next step to redesign it to capture forward-looking risks that the FRTB may miss.

2. Barr Previews Multi-Scenario Stress Tests

In a speech at the Federal Reserve’s stress testing research conference this week, Vice Chair for Supervision Michael Barr called for stress tests with multiple scenarios. These scenarios would likely take the form of “exploratory” scenarios designed to understand a bank’s response to certain stressors, rather than to set the bank’s capital requirements, he said. The spring bank failures demonstrated that banking turmoil can arise even without a recession, Barr said. He highlighted what he sees as key limitations of the current single-scenario stress test framework, including models trained on historical data and the potential for banks to change their behavior or asset allocation based on stress test expectations.

• Macro backdrop: Additional scenarios could explore the effects of different macroeconomic environments, Barr suggested – for example, an inflationary supply shock scenario, or a scenario that explores the interplay between capital and liquidity.
• New market shocks: Additional market shocks in the stress test could test the exposure of firms to risks such as a sudden rise or fall in certain asset values, or an unexpected divergence in the value of correlated assets, he said.
• Small business investments: The Fed will adjust the 2024 stress tests by removing investments through the Small Business Investment Company program from the global market shock and treating it more like affordable housing investments which have a very small loss rate.
• Double count: During the Q&A portion of Barr’s remarks, he pushed back on the notion of a double-count of risks in the Basel proposal and the stress tests, though he said he is open to feedback about stress testing. “I think it’s incumbent on us to always look at the stress test models we’re using and making sure that they are testing complementary risks in the system, and that we’re getting it right, that we’re getting the calibration right. And so, I’m open to that kind of feedback about our stress testing framework, but I don’t think that the double-counting criticism is the right conceptual way to think about whether we’re getting it right.”
• Next steps: “Building on these experiences, the Federal Reserve is developing both exploratory macroeconomic scenarios and exploratory market shocks for next year’s stress test,” Barr said. “As I noted above, an exploratory scenario would not be used to set a firm’s stress capital buffer requirement. Instead, the exploratory scenarios will be used to inform the Board’s supervisory assessments of firms’ risk management and our understanding of different risks in the banking system.”

3. Lawmakers Demand More Details on Basel

Congressional scrutiny of the Basel proposal intensified this week as Rep. Andy Barr (R-KY) wrote to Federal Reserve Vice Chair for Supervision Michael Barr that he had failed to answer many questions about bank capital measures in a recent letter. Rep. Barr was referring to the Fed’s response to a bipartisan letter that he and Rep. Bill Foster (D-IL) had previously written to Vice Chair Barr on capital. Not only did Vice Chair Barr fail to provide an analysis to support his “holistic review” of capital requirements, Rep. Barr said, but the Basel proposal also lacks adequate analysis. “It is unacceptable that the Vice Chairman for Supervision of the Federal Reserve is leading those changes in an opaque manner, including failing to respond in a fulsome manner to a bipartisan request from Congress,” Rep. Barr wrote.

• “Failure”: Rep. Barr wasn’t the only member of Congress to express strong criticism of the Basel Endgame proposal this week. The proposal, “as written, is a failure,” said Rep. French Hill (R-AR), a fellow senior member of the House Financial Services Committee, in remarks at the Exchequer Club. Policymakers’ original intention behind Basel III was not to raise capital, Hill noted. “If this new proposal abandons capital neutrality and doubles down on gold-plating more capital for U.S. banks, despite Congress not authorizing that or directing that, we’ve got a problem with that,” Hill said.

4. Fed to Weigh Changes to Debit Interchange Fee Cap

The Federal Reserve will discuss potential changes to its debit interchange fee cap at a public meeting on Oct. 25, according to a notice. The measure would lower the cap on such fees, according to the Wall Street Journal this week. The cap arose from the Durbin Amendment in the Dodd-Frank Act, which enabled the Fed to cap debit interchange fees.

• What to expect: It’s not yet clear if the Fed will issue a full-fledged proposal at this meeting; it could instead simply open the topic up for discussion in the form of a Request for Information or similar action.
• Implications: Lowering the cap would limit revenue streams that enable banks to offer products like free checking accounts that particularly benefit lower-income customers. Ultimately, big-box retailers, not consumers, would benefit from a lower debit interchange cap.
• Capitol Hill context: The potential changes come as Congress has been considering legislation to impose new mandates on credit card network routing. This measure would similarly enrich large retailers at the expense of consumers.

5. BPI Supports Stronger Customer Protections, End to Exploitative Data Harvesting in Section 1033 Rulemaking

The Consumer Financial Protection Bureau proposed a new rule this week to govern how consumer personal financial data is shared and secured. This rulemaking, sometimes referred to as “open banking,” is part of a requirement under Section 1033 of the Dodd-Frank Act.

What BPI is saying: Paige Pidano Paridon, BPI senior vice president and senior associate general counsel, issued the following statement in response: “BPI supports innovation and welcomes competition in financial products and services and the ability of bank customers to securely connect their bank accounts to third-party apps. The CFPB must prioritize data security in its rulemaking process, put an end to unsafe practices like screen scraping and require fintechs to adhere to the same data privacy and security standards that already apply to banks.”

What is BPI’s position? Put simply: customers must have transparency and control over their data. Around 80% of consumer respondents were unaware that third-party app providers gather users’ financial data and 78% were unaware that aggregators have access to personal data even when the app is closed or deleted, according to a recent survey.

The final rule must:

• Advance the adoption of secure APIs and set a date to phase out the use of screen scraping;
• Require any entity with access to sensitive consumer data to establish and maintain strong data security safeguards and subject those entities to CFPB oversight;
• Limit the type and amount of data shared to what is necessary for the desired product or service;
• Require transparency so that customers understand how their data is being used, who it is being used by and for how long the data is being saved; and
• Require any entity that causes harm to a consumer be responsible for remedying the harm. For example, if a data aggregator is hacked and a consumer’s data is accessed and used to engage in fraudulent activity, the data aggregator should be liable for that breach.

To learn more about what’s next, click here.

In Case You Missed It

CRA Vote Slated for Oct. 24

The Federal Reserve and FDIC have scheduled votes for Oct. 24 on the agencies’ revised Community Reinvestment Act rules, according to sunshine notices. The OCC, which also participated in the rulemaking, will presumably vote on the measure around the same time. The agencies had originally planned to vote on the CRA rules earlier this month, but the vote was delayed due to legal concerns by the Fed’s general counsel, according to a report by Capitol Account.

Senate Targets CFPB Small-Business Lending Rule

The Senate voted 53-44 this week to overturn the CFPB’s Section 1071 rule, which aims to gather information about banks’ small-business lending. Sen. John Kennedy (R-LA) decried the rule’s demographic questions about business borrowers, such as questions about race and sexual orientation, as “intrusive.” The lawmakers used the Congressional Review Act, a statute that enables Congress to invalidate federal regulations. The House would need to vote on the bill for it to move forward, and the White House has threatened to veto it.

• Legal limbo: The CFPB rule is under pressure in the courts, too – a Texas federal court suspended enforcement of the measure for members of trades that sued the Bureau until the Supreme Court case over the CFPB’s funding is resolved.

Lawmakers Call for Transparency on Fed CSI Leaks

A group of Republican lawmakers on the House Financial Services Committee called on the Federal Reserve to provide more details on alleged leaks of confidential supervisory information to the media. The lawmakers, led by Rep. Andy Barr (R-KY), posed several questions in a letter to Chair Jerome Powell regarding leaks of secret bank supervisory data, including whether Matters Requiring Attention or Matters Requiring Immediate Attention were provided to the press. They also questioned Powell about what systems are in place at the Fed to identify unauthorized disclosure of such information. The letter expresses concern about the possibility of the information coming from the Fed. The House letter follows a recent letter from a group of Senate Banking Committee Republicans expressing concern about the same leak, which centers on a Bloomberg article in late August about certain banks receiving increased supervisory scrutiny. The House letter also mentions a Bloomberg article from July that included details on the then-forthcoming Basel proposal and its treatment of mortgages.

Treasury Unveils New Sanctions on Hamas Operatives

The U.S. Treasury Department this week imposed sanctions on 10 Hamas operatives and financial facilitators. The action targeted a key Hamas leader, a Gaza-based digital currency exchange and its operator, and asset managers of a secret Hamas investment portfolio.

• Crypto funding: A recent Bloomberg opinion piece commended policymakers for cracking down on crypto terrorism funding, including Hamas.

U.S. Supreme Court to Consider Scope of National Bank Act Preemption in Escrow Interest Case

The U.S. Supreme Court late last week agreed to consider a case testing whether, or to what degree, federal banking law preempts a state law requiring the payment of interest on mortgage escrow accounts.  The case, Cantero v. Bank of America, specifically presents the question of whether a national bank is required to comply with a New York law that requires banks to pay a minimum interest rate on funds held in escrow.  Importantly, it will be the first time that the Supreme Court will be addressing national bank preemption since the enactment of the 2010 Dodd-Frank Act which included a preemption standard for certain state consumer financial laws that draws upon the holding in the Supreme Court’s 1996 Barnett Bank case.  The outcome of the case is expected to serve as important precedent as to whether or not national banks are bound by state laws that conflict with the federal banking scheme.

The Crypto Ledger

The Basel Committee on Banking Supervision this week proposed a standardized format for banks to disclose holdings of crypto assets to investors, from January 2025. The measure comes after the BCBS issued new rules last December on how much capital banks should hold for different types of crypto assets. Here’s what else is new in crypto.

• Bowman on payments: Federal Reserve Governor Michelle Bowman expressed concern about risks posed by retail CBDC and by stablecoins in a recent speech on payments innovation. On CBDC, she said “I believe it is important to continue to research the possible benefits, risks, and tradeoffs of a potential U.S. CBDC, and to follow international CBDC developments that could have implications for the United States. However, given that we have a safe and efficient payment system and a well-functioning banking system, the potential uses of a U.S. CBDC remain unclear and, at the same time, could introduce significant risks and tradeoffs.” On digital assets, Bowman stated: “While I support responsible innovation that benefits consumers, I caution against solutions that could disrupt and disintermediate the banking system, potentially harming consumers and contributing to broader financial stability risks. And, where the activity happens outside the regulatory perimeter, consumers would be left without the adequate protections that our regulated and supervised banks provide today in the United States.”
• FDIC crypto oversight: The FDIC plans to strengthen its understanding of crypto risks in the banking system, according to an FDIC inspector general report this week. Forthcoming steps may include a risk assessment analyzing crypto asset activities’ risks to bank safety.
• SBF on trial: The trial of FTX founder Sam Bankman-Fried continued this week, as former FTX colleague Nishad Singh testified that Bankman-Fried used customer funds to finance “excess” spending sprees.
• Digital euro: The ECB this week announced that it is embarking on the next phase of considering a digital euro – the “preparation phase,” which will “initially last two years.” This phase of the process will entail finalizing the rulebook for a digital euro, selecting providers that could develop its platform and infrastructure, testing a digital euro that meets various needs such as privacy and financial inclusion, and engaging with the public and stakeholders. POLITICO reported this week that political backlash over privacy concerns has tempered the EU’s pursuit of a digital euro.

BofA Unveils Recipients of Neighborhood Builders Social Equality Award

Bank of America this week announced the latest honorees of its Neighborhood Builders Social Equality Award (NBSE), which recognizes leaders from across the country who are instrumental in advancing social equality and economic opportunity. The six recipients were selected for their meaningful contributions to breaking barriers and creating opportunities.