BPInsights: October 28, 2023

Basel’s Economic (and Legal) Endgame

Capitol Account hosted an event sponsored by BPI on Oct. 25 to examine the Basel Endgame proposal. The event featured remarks by Rep. Andy Barr (R-KY), followed by a discussion moderated by Jessica Holzer and featuring Gibson, Dunn & Crutcher Partner Eugene Scalia, BPI President and CEO Greg Baer and Barclays Equity Analyst Jason Goldberg.

Here are some key highlights from the event.

  • ‘Defining issue’: This is a ripe moment in the legal system for regulated industries to sue overreaching regulators, Gene Scalia suggested. The re-examination of the administrative state “could well be the defining issue” of the current U.S. Supreme Court, he said. “You do have some regulators right now that are serving up a lot of softballs to the federal courts,” he also said.
  • Pushing for consensus: Rep. Andy Barr said he is pressing Federal Reserve Chair Jerome Powell “to live up to his commitment to consensus on the Board” on the capital proposal, which evoked dissents from two Fed governors and misgivings from Powell and others. “We’re going to hold Chairman Powell’s feet to the fire on that point.”
  • ‘Incomplete’: The proposal is an “incomplete” document, Scalia said, with short and scant economic analysis. “The agencies need to show their work,” he said. “When an agency relies on studies, when it projects impacts, it needs to give not merely that projection, it needs to explain how it got there.”
  • Other weaknesses: The international Basel agreement, the supposed basis for the proposal, is not a legally binding treaty, “and there are some federal judges out there who would not take kindly to the notion that if unelected American regulators go overseas and strike a deal with unelected regulators from other countries, that somehow gets to circumvent U.S. legal requirements and just get dropped into the U.S. Code somehow — not the way it works,” Scalia said. He also laid out other fatal flaws that can doom regulations in court, such as so-called ipse dixit or “because I say so” justifications.
  • Permanent costs: The immediate costs of higher capital, such as exacerbating a potential credit crunch, are less alarming than the permanent reduction in GDP that could result from it, Greg Baer said. “When you increase capital, permanently, you decrease GDP permanently,” he said.
  • Where it hurts: Jason Goldberg parsed the specific markets that could be hit by the proposal, including low down-payment mortgages, small business lending and corporate borrowers’ access to capital markets. Rep. Barr expressed concern about the effects on regional banks, stressing the need for a diverse banking system.
  • Why banks: When explaining how the proposal would push financing into the nonbank sector, Greg Baer emphasized that banks are best suited to meet customers’ mortgage needs not because they’re “smarter or nicer”, but because they have stable, low-cost deposit funding that makes them more reliable than fair-weather lenders.

Five Key Things

1. BPI, CBA and TCH Respond to Fed Abbouncement on Reg II

BPI, the Consumer Bankers Association and The Clearing House issued the following statement in response to the Federal Reserve’s proposed changes to Regulation II, which establishes caps on what banks can charge for facilitating debit card transactions: “The last time the Federal Reserve placed a cap on debit transaction costs, two things happened: the availability of free checking accounts declined and merchants pocketed the difference in cost, defaulting on their promise to the American consumer to lower costs at the counter. Attempting to revisit the failed policy in a world where technology and fraud prevention costs are even higher will exacerbate these problems and further harm consumers.”

The Truth is, Since Regulation II Became Effective in 2011:

  • Merchants didn’t lower prices.
  • Account holders have experienced higher checking account fees and lower availability of free accounts.
  • Bank investments in technology and fraud prevention have risen.
  • Banks of all sizes were affected.
    • Although the Board’s 2011 rule was supposed to protect small community banks and credit unions from the impact of the interchange fee price controls, data and reports from smaller banks and credit unions suggest that even the exempt institutions have been harmed. 

2. Regulators Issue Final CRA Rule

The Federal Reserve, FDIC and OCC this week approved a final rule on the Community Reinvestment Act. Fed governor Michelle Bowman voted against the rule, as did FDIC board members Jonathan McKernan and Travis Hill. The action concludes a long-awaited process to revise the rules on an interagency basis. The final rule maintains some aspects of the proposal but makes several key changes.

  • Longer compliance period: The final rule enables more time for banks to comply with new requirements compared to the proposal.
  • Downgrade scope: The final rule would maintain the current standard for CRA ratings downgrades only for “discriminatory and other illegal credit practices”, as opposed to the proposal’s much broader standard.
  • Retail Lending Test: The final rule’s Retail Lending Test, which would evaluate banks on various retail loan offerings, would examine three product lines for most banks as opposed to six in the proposal. The agencies would only evaluate auto lending at banks for whom auto loans make up a majority of their lending portfolios. Governor Bowman expressed concern that the final rule’s calibration of retail lending evaluations would lead to unjustified low ratings. “This proposal effectively requires a number of banks to change their business plans to satisfy the new retail lending test,” she said in a statement.
  • Trigger thresholds: The final rule increased the number of home mortgages and small business loans that would trigger a new “retail lending assessment area” to subject banks to evaluations. Bowman asserted that the establishment of these new assessment areas were likely “beyond the scope of” the agencies’ “authority under the statute.”
  • Benchmarks: The final rule maintains some benchmarks for banks’ performance that would be unknowable in advance of being tested, which Bowman said “raises potential due process concerns.”

3. The Long-Term Debt Proposal and the Liquidity Coverage Ratio

The federal banking agencies recently proposed a rule to require large regional banks to issue long-term debt. The rule would apply to U.S. banks with assets over $100 billion that are not considered global systemically important banks (GSIBs). This rule poses two significant problems.

The background: The proposed rule applies to both banks and their parent companies, known as bank holding companies. Under the proposal, all mandatory externally issued long-term debt would have to be raised by a bank’s parent company, with the proceeds channeled to its subsidiary banks as internal long-term debt.The regulators’ estimate of a $20 billion shortfall for Category III firms’ long-term debt is an underestimate for two reasons.

  1. The proposed rule does not examine a realistic scenario where the parent company meets the debt requirement but does not have liquid assets to downstream to its subsidiary bank.
  2. The proposal does not consider the effects of downstreaming debt from the parent to subsidiary banks on the bank holding company’s liquidity coverage ratio – some banks may need to issue more debt because they cannot maintain the required LCR at the parent level while altering the balance sheet at the bank level.

These two factors increase the shortfall of banks subject to the LCR to nearly $65 billion – 2.3x higher than the banking agencies’ projections.

The big picture: Since the March bank failures, regional banks have faced increased funding-cost pressure. Forcing these banks to issue a large amount of long-term debt would exacerbate such pressure. For many regional banks, offering affordable loans with reasonable credit risk levels has become more challenging. The new requirement will likely prompt banks to issue most of their external debt from the parent company, which usually results in higher credit spreads than their banking subsidiaries. This could also lead to higher debt spreads, because the market would need to absorb a much larger amount of long-term debt.

What could help: The banking agencies could lower the calibration of subsidiary bank requirements and offer flexibility that alleviates pressure from the confluence of the LCR and the long-term debt requirement. For example, they could permit long-term debt to be excluded from trapped liquidity or allow banks to issue a support agreement from the parent company that promises overnight deposit funds to the bank in case of deterioration. The banking agencies could also offer flexibility in satisfying long-term requirements through existing debt, intercompany deposit liabilities, or new debt issuances at the bank level.

The bottom line: BPI analysis reveals that the long-term debt proposal considerably underestimates the long-term debt shortfalls banks are facing. One major reason for this shortfall is that banks are unable to substitute the parent’s overnight deposits at the bank with internal long-term debt without notably affecting the liquidity coverage ratio of the bank holding company. To maintain their LCR levels, holding companies would need to issue a substantial amount of long-term debt.

4. Powell: Banks Are Well Capitalized; Will Take Capital Input Seriously

Federal Reserve Chair Jerome Powell weighed in on the state of bank capital in a recent Q&A at the Economic Club of New York. “Banks are generally very well capitalized and highly liquid in our country,” Powell said. “Banks are strong. We benefit from all those years of reform, and Basel III, that we went through, with former Governor Tarullo and many others. And so we benefit from a very strong well-capitalized banking system that is much better at managing its risks than the one that entered the global financial crisis.” In response to the interviewer, Bloomberg’s David Westin, saying, “Very well-capitalized, but you want some more,” Powell said he could not say much while the rule is out for comment, but “we do expect a lot of comment, and we do expect to take those comments very seriously.”

5. WSJ: Smaller Banks Look to Shrink Their Way Back to Health

Regional banks under earnings pressure from higher deposit rates are shrinking and simplifying their business models, the Wall Street Journal reported this week. The article captures a trend evident in third-quarter earnings reports from midsize banks, with several exiting or selling lines of business like student loans, auto loans and mortgages that offer lower returns.

  • Regulatory implications: The Basel proposal, which increases capital costs for regional banks, can only exacerbate this challenge. At a BPI-sponsored Capitol Account event this week, longtime Barclays bank analyst Jason Goldberg spelled out the pressures facing regional banks’ business models and the likely need for M&A in the sector.

In Case You Missed It

Geopolitics, China, Deposit Pressures: The Financial Stability Risks the Fed is Watching

The Federal Reserve recently released its regular Financial Stability Report. The report observed that the banking system is generally sound and well capitalized, but some banks are experiencing funding pressures due to the higher price of deposits. The report also flagged Treasury market liquidity as relatively low. “Measures of regulatory capital for banks increased over the first half of the year and remained solid,” the report said. “Nevertheless, declines in the fair value of fixed-rate assets have been sizable relative to the regulatory capital at some banks, especially for a subset of large (but non–global systemically important) banks and regional banks.”

  • Credit crunch: A broader economic downturn could cause banks to pull back on lending, the report warned. Such a slowdown could strain the commercial real estate sector, though the report noted that the stress tests demonstrate that large banks could withstand a severe recession and CRE market contraction.
  • Macro factors: Persistent inflation, financial and economic strains in China and geopolitical conflicts could pose risks to the U.S. financial system, the report said.  
  • Unstable stablecoins: Stablecoins remain vulnerable to runs, the report noted.

BPI Welcomes FDIC Action to Provide Certainty for Banks’ Second-Chance Hiring

The FDIC this week approved a proposal to conform FDIC rules with legislation enacted last December that gives banks more flexibility to hire people with minor criminal records. That legislation, the Fair Hiring in Banking Act, amended Section 19 of the Federal Deposit Insurance Act to broaden the ability of job candidates with minor records to work in the banking sector. The FDIC action is aimed at updating FDIC rules to reflect these legislative changes, including by specifying the types of offenses covered by Section 19.
What we’re saying: “Banking industry jobs come with fair pay, stable schedules, pathways to advancement and other benefits that set them apart. A more diverse talent pool for banking jobs that includes second-chance candidates will benefit job seekers and the economy as a whole. This FDIC action is an important step providing greater clarity to second-chance job candidates and welcoming them into the banking workforce.” – BPI President and CEO Greg Baer
Here’s the background: The banking industry has historically faced unique restrictions on second-chance hiring. Section 19 of the Federal Deposit Insurance Act sets limits on banks’ ability to hire job candidates with prior criminal offenses. The legislation enacted last year aims to expand banks’ ability to offer second-chance job opportunities for certain candidates, such as those whose prior offenses occurred seven years ago or more. The legislation changed the underlying statute to streamline regulatory approval processes for hiring candidates with minor records. Although the statute was immediately effective, the FDIC’s action this week is necessary to align the regulations with that legislative change and provide more certainty to job seekers. Comments on the proposal are due 60 days after publication in the Federal Register.

Bottom line: The steps taken by the FDIC and Congress will support more opportunities for rehabilitated candidates to pursue stable, high-quality banking jobs. Learn more here.

Noteworthy Nuggets from a Post-SVB Analysis

A recent analysis from the Center for Financial Stability offers views on supervision and regulation after the Silicon Valley Bank failure. The report, by a group including former FDIC Chair Sheila Bair, JPMorgan’s Joyce Chang, former Bank of England adviser Charles Goodhart, makes observations about flaws in SVB’s supervision and examines various proposals for post-SVB regulatory changes. Here are a few key quotes from the report:

  • Banking 101: Enhanced prudential standards – a heightened form of regulatory scrutiny – “should not have been needed for supervisors to catch and remediate the fundamental mismanagement of these banks which violated basic ‘Banking 101’ principles of asset and liquidity management.”
  • Backward-looking examiners: The report observes that bank examiners are often mired in backward-looking, box-checking reviews rather than homing in on the most salient problems. “Instead of being encouraged to adapt to current conditions and emerging risks, bank examiners are too often laden with backward looking check lists, bureaucracy, and cumbersome layers of review. They should be encouraged to focus on major problems that heighten the risk of bank failures, but instead frequently feel obliged to identify scores of MRAs and MRIAs which can number into the hundreds at the largest institutions.”
  • Ready at the window: In an apparent reference to Basel Endgame, the authors recommend: “Before laying on a host of new rules, bank regulators should fix problems imbedded in the current system,” such as “steps to improve banks’ access to stable liquidity.” This includes “giving banks the ability to pre-position collateral with the Federal Reserve for immediate access to central bank loans if and when needed.” (Banks can and do pre-position collateral at the window – see here.)

The Crypto Ledger

Sam Bankman-Fried launched his defense during the FTX founder’s fraud trial this week. Here’s what else is new in crypto.

  • Waller: At a Fed payments conference this week, Federal Reserve Governor Christopher Waller expressed skepticism about central bank digital currency. “About two years ago I posed the question: What is the fundamental market failure a central bank digital currency will solve?” he said. “I have yet to hear a convincing answer.” Most of Waller’s remarks focused on FedNow and payments innovations.
  • Terrorism funding: Senate Banking Committee Chair Sherrod Brown (D-OH) said the panel plans to probe terrorist financing through cryptocurrency.
  • Vehicle for crypto bill: House Financial Services Committee Chair Patrick McHenry (R-NC) may try to include his crypto market regulation bill in the National Defense Authorization Act, according to Rep. Andy Barr (R-KY) at a BPI-sponsored Capitol Account event this week.

Ted Pick to Take CEO Helm at Morgan Stanley

Morgan Stanley Co-President Ted Pick will take over as the bank’s next CEO, succeeding James Gorman, the bank announced this week. Pick will take the helm on Jan. 1, 2024.

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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.