BPInsights: October 7, 2023

The Basel Proposal: What It Means for Mortgage Lending

The U.S. banking regulators’ Basel capital proposal increases capital requirements for most mortgages relative to the current U.S. rule, and by even more compared to what is specified in the latest international Basel agreement. The regulators’ proposal includes both higher capital charges for the credit risk of a mortgage as well as a new, additional capital charge for operational risk, and will make mortgages more expensive and homeownership less affordable.

Which mortgages? Mortgages with high loan-to-value (LTV) ratios, that have lower required down payments, would have the highest risk weights under the proposal. These mortgages are disproportionately relied on by low- and moderate-income and minority households.

Why it matters: Homeownership is a crucial pathway to generational wealth-building and prosperity for American families. Reduced affordability of home mortgages due to the proposed capital increases could place homeownership further out of reach for many low-and moderate-income and minority families as well as many first-time homebuyer households.

To learn more about these consequences, read the note here.

• In the news: See an Axios article on this research here.
• Analyst coverage: The research was also covered by Jason Goldberg in Barclays’ Bank Brief and Capital Alpha Partners’ Ian Katz.

Five Key Things

1. Fed Reportedly Delaying CRA Rules Due to Legal Weaknesses

The Federal Reserve will likely delay a vote on revised Community Reinvestment Act rules after its general counsel, Mark Van der Weide, flagged legal vulnerabilities in the measure that could leave the Fed vulnerable to a legal challenge, financial policy newsletter Capitol Account reported this week. The banking agencies had been planning to approve the rules Friday, Oct. 6, according to the report, but some Fed governors “got cold feet” after hearing from the general counsel.

• Between the lines: “It’s unusual for the Fed’s top lawyer to raise red flags so late in the game, according to people familiar with how the central bank operates,” Capitol Account reported. “The situation puts governors in a tough spot: Do they stop the rule at this late stage or go ahead and finalize it over the concerns of the general counsel?”

2. Op-Ed: Higher Capital Requirements Would Hurt Low-Income Americans

The Basel capital proposal would harm low-income communities the most, according to a recent op-ed by Mario H. Lopez, president of the Hispanic Leadership Fund. The proposed increases would make it harder to buy a home, build credit and finance small businesses. These consequences are of particular concern in the Hispanic community, which has relatively low wealth, Lopez said.

• Key quote: “The zeal for more rigorous capital requirements is another example of Washington failing to consider how harsher regulations would exacerbate key economic challenges and hurt consumers in the long run. During a time of economic uncertainty, we should not pursue an agenda that will cut Americans off from needed financial services like loans and mortgages.”
• Missing the mark: Regulators are pointing to this spring’s bank failures to justify the capital increases, but “the proposed rules would not have prevented the fundamental problem of mismanagement by both bank leadership and regulators,” Lopez wrote.
• Taking action: Lopez called for lawmakers to demand accountability from federal policymakers on the capital proposal, “even if that means holding up new nominations to the Federal Reserve.”

3. Reality Check on ‘Record Bank Profits’

A typical refrain from large-bank critics is that banks are making record profits and rewarding shareholders over other stakeholders. The sentiment came up again this week as Senate Banking Committee Chairman Sherrod Brown (D-OH) asserted that “Wall Street megabanks continue to make record profits and to reward corporations that raise prices on Americans.” 

But that’s missing the point. Banks along with practically every industry are making “record profits,” which is more a function of inflation and overall economic growth. What matters is that banks overwhelmingly lag the rest of the market, based on standard profitability measures.

Investors keen on understanding the health of an industry focus on measures like stock returns and price to book ratio instead of nominal measure of bank profits. These metrics provide a clearer picture of the true profitability of an industry and how much confidence investors have in its future earnings.

In terms of such metrics, the bank stock return index has trailed the S&P 500 by 250% over the past 15 years. Moreover, banks’ current price-to-book ratio (which is how much a company is valued relative to the book value of its assets) stands at 1x, while the S&P 500 is at 4x. Critics often overlook these facts, but healthy, investable banks are necessary for a stable system that can support the economy and weather stress.

4. In CFPB SCOTUS Case, Justices Appear Skeptical that CFPB’s Funding is Unconstitutional

The Supreme Court heard oral arguments this week in a case on the constitutionality of the CFPB’s funding structure. The Community Financial Services Association of America and the Consumer Service Alliance of Texas, two payday lending trade associations, sued the CFPB and asserted its funding model is unconstitutional. Unlike some other agencies, the CFPB can draw funding from the Federal Reserve up to a certain amount rather than relying on annual Congressional spending bills. Critics of the Bureau say this structure makes the agency unaccountable to Congress. This week, several justices posed questions that suggest the CFPB may have a good chance of winning the case.

• More specific: Several justices asked the trade groups for more details on their concerns. Justice Brett Kavanaugh took issue with their characterization of the CFPB’s structure as a “perpetual” appropriation outside of Congress’ control. Justice Amy Coney Barrett said she struggled to pinpoint what the plaintiffs believe the standard should be for how much budgetary discretion can be given to an agency like the CFPB. Justice Clarence Thomas said he would need a specific constitutional basis to rule against the CFPB’s funding structure, even if it is unique. Justices Elena Kagan, Sonia Sotomayor and Ketanji Brown Jackson also directed several skeptical questions toward the plaintiffs.
• Precedent? U.S. Solicitor General Elizabeth Prelogar, representing the CFPB, said the text of the Appropriations Clause of the Constitution has no explicit restrictions on Congress’ power to appropriate funds, other than two-year limits on military appropriations. She cited other financial regulatory agencies like the Federal Reserve and OCC that get funding outside of regular appropriations. Justice John Roberts pushed back on Prelogar’s assertions, which he said constituted a “very aggressive view” on how much power Congress has over appropriations under the Appropriations Clause.
• Not the first time in court: This is not the first time the CFPB has been subject to high court debate. The Seila Law case in 2020 struck down limits on the president’s ability to fire the CFPB director, another aspect of the Bureau’s structure that raised concerns of unaccountability.
• What’s at stake: Should the Court rule that the CFPB’s funding structure violates the Constitution, the CFPB’s past and pending rules and guidance could be vulnerable to being deemed invalid.

5. Bowman: Regulators Must Show Their Work

Federal Reserve Governor Michelle Bowman emphasized the crucial role of research in forming bank regulations in a speech this week. “Research can protect against over-reactive regulation, especially that which is not efficient, calibrated and tailored to address the actual risks and challenges facing the banking system,” Bowman said. Much of her speech focused on community banks.

• M&A: In bank M&A evaluations, policymakers should take competition from nonbanks like credit unions and fintechs into account, Bowman said. “In our current system, many of the competitors and new entrants that we do have (nonbanks, fintech firms, credit unions), are systematically ignored,” she said. She observed that nonbanks are increasingly dominating the mortgage lending market, and yet nonbank mortgage lenders are not seen as competitors in bank merger analysis. She also emphasized the negative consequences of lengthy merger reviews – “loss of key staff, pauses on new investment and development of new consumer and business products, expensive delays in systems integration, reputational risk, and shareholder losses.”
• Deposit insurance: She also called for research into deposit insurance to inform potential overhauls, such as the options laid out in an FDIC report on the topic earlier this year.
• Outside eyes: In separate remarks, Bowman reiterated the call for an independent review of the spring bank failures. A full understanding of the causes of the failures would inform policymakers as they consider potential new regulations, Bowman said. She flagged potential shortcomings in bank examiners’ reliance on call report data rather than engaging directly with banks. “Financial results are key, but in the continuum of supervision, we should not forget the value of a broader based supervisory approach that uses all available tools and considers all relevant factors,” Bowman said.

In Case You Missed It

FDIC’s McKernan: Basel Proposal is ‘Leap of Faith’

The U.S. Basel capital proposal is “underdeveloped” in some ways, with gaps that warrant further explanation, FDIC board member Jonathan McKernan said in a speech this week. “I don’t think the regulators are intentionally trying to hide the ball,” he said. “Instead, what’s unique here is that we’re implementing standards developed by a third party—the Basel Committee—and the Committee itself offered little to no explanation for some of its decisions. That then leaves us simply guessing, unable to defend or perhaps even understand important aspects of the Basel standards we’re trying to implement. In short, and I would put some emphasis on this, the proposal amounts to a big leap of faith in the Basel Committee.”

• Op risk: One gap in the proposal is on operational risk, McKernan said. The Basel Committee has acknowledged that its approach would overcapitalize for banks with high fee revenues, such as credit card banks or banks with wealth management businesses, and it proposed a fix for the issue, but then dropped it from the final standards without explanation. “That leaves us trying to defend an approach for operational-risk capital that its own Basel authors have said does not work for high-fee-revenue banks,” McKernan said. Revisions to the formula for operational risk in the final standards are also unexplained, he said. McKernan named several other examples, such as elements of the market risk framework, that lack adequate explanation.
• Harmony or cacophony: McKernan questioned whether the proposal aligns with the goal of leveling the playing field across similarly situated market participants, while taking into account differences in risk profiles and business models. “I’m left struggling to see how we can work to harmonize requirements across banks and nonbanks when we have sometimes not offered a calibration rationale for the bank requirements, and indeed some aspects of the Endgame proposal arguably might even be contrary to the available evidence,” he said. He pointed to the proposal’s approach to mortgages as an example, saying that the GSEs came to dominate the U.S. mortgage market after bank capital requirements rose. The proposal could have taken an opportunity to harmonize credit risk capital requirements across the banks and GSEs to make the market more balanced, he said, but instead regulators chose exacerbate the situation by adding a 20-percentage-point surcharge on the Basel Committee mortgage risk weights. “Compounding the enigma here, we offered no loss history or other evidence to support the sizing of the surcharge,” he said.
• Long-term debt: McKernan raised questions about potential unintended consequences of the banking agencies’ recent long-term debt proposal. The proposal’s prescriptive requirement for the external issuance of long-term debt out of the top-tier U.S. parent company for bank subsidiaries) could mean regional banks have less flexibility in how they position their assets and develop their resolution plans.

A Deeper Dive on Uninsured Deposits

Bank failures this spring featured rapid runs of uninsured deposits. Silicon Valley Bank and Signature Bank were unusually dependent on such deposits, which appeared to be highly concentrated by size and industry.

A key question: If SVB and Signature’s situation is abnormal, what’s the norm among U.S. banks? And what, if anything, should policymakers do about banks’ uninsured deposits? A new BPI blog post uses bank call report data to examine how much other U.S. banks were funded by uninsured deposits and how much they suffered runoffs of those deposits early this year.

What we found: Many other U.S. banks of various sizes had uninsured deposits equal to a large share of their total deposits, but very few had shares anywhere near as large as those two failed banks. Furthermore, while some other U.S. banks, small and large, experienced significant runoffs of uninsured deposits in the first quarter of 2023, runoff rates varied widely and very seldom were more rapid than the runoff rates assumed in the liquidity coverage ratio (LCR), a key measure applied to the largest banks.

Next steps: It’s not clear that broad new policies are necessary to address risks surrounding uninsured deposits. Such steps come with their own risks: balance sheet adjustments that would reduce credit availability to businesses and households. Instead, regulators could focus on banks that are heavily reliant on uninsured deposits, requiring those banks to measure and monitor dependence on, and concentration within, the more unstable types of those deposits. Regulators could use this information to form enhanced supervisory and regulatory policies that promote reliable, well-diversified funding. Policymakers should also ensure banks are ready to use the Fed’s discount window when deposit outflows exceed expectations. A targeted approach to uninsured deposits could improve safety and soundness while avoiding the credit-constraining adverse effects of broader measures based on limited information.

Gary Cohn: Bank Regulators Aren’t Graded on Economic Growth

Former National Economic Council Director Gary Cohn weighed in on bank capital requirements in a recent media interview. Banks aren’t lending as much because they don’t have the excess deposits they had at the beginning of the pandemic, he said, and on top of that, the Federal Reserve is proposing to raise capital requirements. He also noted that economic growth is not the metric by which regulators are graded. “In the banking regulatory community, remember, their policy is, we want to protect the depositors at all costs; we’re not really graded upon growing the economy and creating loans,” Cohn said in an interview with Semafor. “As much as Congress would say it’s our incentive and it’s our goal to create homeownership and create small business, because small businesses grow the economy, the banking regulators don’t sit there and say ‘did you lend money to small businesses?’” Regulatory requirements motivate banks to focus lending on more creditworthy borrowers, he noted.

• M&A: Cohn observed that there is a negative regulatory environment for bank M&A. “They think that smaller is better,” Cohn said. “In the banking world in particular, they’ve been pretty anti-mergers.” He predicted there would be more consolidation, but “unfortunately we’ll see it in the negative fashion” through “brokered marriages” instead of regulators proactively encouraging banks to merge now.

Barr Calls for Discount Window Readiness

Federal Reserve Vice Chair for Supervision Michael Barr called for banks to be ready to use the Fed’s discount window to meet sudden liquidity needs. “I have been working to ensure that eligible institutions know that supervisors expect them to be ready and willing to use the discount window,” Barr said in a speech this week on the interplay between monetary policy and financial stability. When funding markets are under strain, the discount window can provide banks an alternative way to monetize their assets, but only if they are ready to use it, Barr said. Using the window requires preparation in advance, such as pre-positioning collateral.

• Stepping back: There is considerable stigma associated with borrowing from the discount window in part because doing so is viewed negatively by examiners. Making banks comfortable with incorporating it into their asset monetization plans is a challenging, but necessary, task for the central bank.

The Crypto Ledger

The fraud trial of FTX founder Sam Bankman-Fried began this week. The jury faces two dueling depictions of the 31-year-old: Ponzi schemer who stole from his customers, or math nerd in over his head. One key witness in the trial will be Caroline Ellison, Bankman-Fried’s former girlfriend and former CEO of Alameda Research, FTX’s trading affiliate. Here’s what’s new in crypto.

• FTX backdoor: FTX employees found the so-called backdoor that Alameda Research used to siphon billions of dollars in customer funds from the crypto exchange months before FTX collapsed, but the problem was never solved despite the employees raising it to their boss.  It is alleged that SBF “stole funds from FTX customers, in part, by secretly ordering the programming of “special features” that gave Alameda—his crypto trading firm—the ability to treat FTX as a giant slush fund.” The secret coding “allowed Alameda to have a negative balance of as much as $65 billion on the exchange,” unlike ordinary users who would be subjected to an automatic liquidation process if their balances fell below zero.
• SEC and Coinbase: The SEC asked a judge this week to reject crypto firm Coinbase’s attempt to have the regulator’s lawsuit dismissed. The request is the latest step in the agency’s pursuit of big crypto players.

Treasury’s Rosenberg: Financial Crime Fighting Should Focus on Key Threats, Not Checking Boxes

An effective approach to combating financial crime must be “outcomes-focused” and risk-based, Treasury Department Assistant Secretary for Terrorist Financing and Financial Crimes Elizabeth Rosenberg said in a speech this week. “It is an area of tension for many countries, including the United States, where many financial institutions often say our regime is geared towards technical compliance, rather than being risk-based and outcomes-focused,” Rosenberg said. “Also, that risk-based approach invites the uncomfortable necessity of breaking us out of our traditional way of doing things to evolve more innovative and novel approaches.” One particular challenge is “to get to a place where supervisors more fully recognize that financial institutions should have flexibility to utilize their resources appropriately to go after illicit financial risks,” she said. Rosenberg said Treasury is engaging with banks and supervisors to encourage such risk-based approaches.

Joint Trades Request Comment Deadline Extension on Long-Term Debt Proposal 

BPI, the American Bankers Association, the Financial Services Forum, the Institute of International Bankers and the Securities Industry and Financial Markets Association on Friday requested from the banking agencies a 60-day extension of the comment period for four resolution-related regulatory proposals, including the recent long-term debt proposal. The confluence of several interrelated proposals with comment deadlines the same day, including the Basel Endgame proposal, could complicate efforts to understand and analyze the effects of these measures. The trades noted that: 

• the number, length, and complexity of the proposals require detailed attention from affected banking organizations;
• understanding certain of the effects of the proposals requires analysis and understanding of the potential effects of other proposals;
• comments on one proposal may relate to or affect comments on another proposal; and
• the same personnel from affected banking organizations are, in many cases, responsible for analyzing the proposals.

“To meaningfully comment on the proposals, it is vital for the public to understand how they all relate to one another and the collective impact that they would have on banking organizations, their customers, and the financial system,” the organizations wrote. The trades requested the comment deadline for the four proposals be extended from Nov. 30 to Jan. 30, 2024, or until the date that is 60 days following the end of the comment period for the Basel III Endgame proposal. 

Citizens Makes it Easier for Small Business Customers to Open New Accounts 

Citizens announced this week that small business customers can now open sole proprietorship deposit accounts through a new digital self-service channel. The convenient digital option will enable small business owners to open multiple products at once and includes standalone checking, savings and money market accounts.