BPInsights: Sept 7, 2024

U.S. Banking Agencies Have an Operational Risk Problem

Reports from the Federal Reserve and the OCC say a significant percentage of banks are poorly managed. Such findings raise questions - "not about the banks and their management but rather about the examination regime administered by the banking agencies and their management," according to a recent International Banker op-ed by BPI CEO Greg Baer. The agencies' findings contradict reality, as it is plain to see in banks' capital, liquidity and earnings and the views of analysts and investors. The divergence arose from examiners "shifting the focus of their examinations from material financial risk to so-called operational risk, and by changing their roles from examination to management consulting," Baer wrote. Read the op-ed here.

• The troublesome 'M': Taking a similar view, an op-ed this week in The Banker by Stephen Scott, CEO of risk management firm Starling, said that a leaked OCC report offers "a rare glimpse into the priorities and practices of a principal US banking regulator and reveals where these fall short." The OCC report depicted half of large U.S. banks as inadequate on operational risk management. Scott focuses in the op-ed on the "M" component (standing for Management) of the CAMELS bank rating system - the most subjective element of the framework, and an albatross that effectively acts as a long-term financial penalty. Operational risk management is part of the M component. The CAMELS rating is considered confidential supervisory information; banks cannot reveal it under threat of legal penalty and therefore cannot contest it. "This is bad policy, antithetical to the principle of due process, and contrary to the basics of a democratic government," Scott wrote. Reliance on subjective assessments and opaque decision-making - and a lack of due process for banks - "stifles innovation, restricts growth and undermines trust," Scott wrote.

Five Key Things

1. A Helpful Fed Statement on Bank Liquidity

On Tuesday, Aug. 13, the Federal Reserve Board brought some helpful clarity to a key part of bank liquidity regulation. The Fed published an FAQ stating that, as part of banks' internal liquidity stress tests, banks can point to their capacity to borrow against their highly liquid assets at the Fed's discount window, the Fed's standing repo facility or Federal Home Loan Banks as a means to convert those highly liquid assets to cash, or "monetize" them. This statement brings more clarity to a question in focus after the failure of SVB.

Some background: Large bank holding companies, those with over $100 billion in assets, must conduct regular tests estimating each bank's liquidity needs under different scenarios and different time horizons. These tests, called internal liquidity stress tests, are an important part of the liquidity regulatory framework for banks. For many banks, these tests are the most binding liquidity requirement. Banks are required to:

• Hold highly liquid assets - deposits at a Federal Reserve bank, Treasury securities, agency-guaranteed mortgage-backed securities - to cover projected outflows of cash under stress.
• Show that they can monetize these highly liquid assets - convert them into cash.

A longstanding challenge with ILSTs is the extent to which borrowing from Federal Reserve Banks or Federal Home Loan Banks against highly liquid collateral can serve as the means by which a bank plans on monetizing its liquid assets. This question was brought sharply into focus by the failure of SVB, which had ample liquid assets but was unprepared to access the discount window or standing repo facility - in part because that access would not have satisfied the monetization requirement in the ILST.

What the FAQ says: The FAQ clarifies that banks can point to their capacity to borrow against their highly liquid assets at the discount window, standing repo facility or a Federal Home Loan Bank as their planned way to monetize their highly liquid assets under the internal liquidity stress test scenarios. This would enable banks to plan to meet a substantial portion of their projected immediate cash needs under stress by borrowing from the Fed rather than just by drawing on deposits maintained at the Fed. It will also motivate banks to be prepared to use the discount window or standing repo facility.

Open questions: The public FAQ release is a constructive step and will enhance transparency and financial stability, but further questions warrant clarification. Learn more in BPI's post.

2. FinCEN Proposal Undermines Goals to Aid Law Enforcement in Fight Against Illicit Finance

BPI this week voiced serious objections to a Financial Crimes Enforcement Network proposal to amend existing rules to combat illicit finance. The proposed rule makes fundamental changes to the oversight of financial institutions' implementation of anti-money laundering and countering the financing of terrorism compliance programs, as required by the Anti-Money Laundering Act of 2020. However, BPI argues in a comment letter that FinCEN is continuing down an unsound path of a one-size-fits-all AML/CFT regime that prioritizes technical compliance over combating and preventing financial crime.

BPI President and CEO Greg Baer issued the following statement upon filing the letter: "Congress in 2020 recognized that the examination process for the AML/CFT regime was broken - focused on documentation and box checking rather than innovation and results - and it issued a sweeping mandate to the Treasury Department to fix it. Sadly, the proposal from FinCEN, however well intentioned, would do little to change the status quo. It reiterates the need for a risk-based approach to compliance but gives banks no assurance that they will not be subject to examiner sanction if they reallocate resources away from any area, and something goes wrong. The proposal sounds good in theory, but its lack of specifics means that it is bound to fail in practice."

BPI's comment letter offers four primary recommendations, including:

• Empower banks to reallocate compliance resources to higher-risk activities. Valuable resources shouldn't be wasted by applying the same AML/CFT resources equally to all financial activities, regardless of the activity's riskiness. Banks should have the authority to shift resources to high-risk activities to better support law enforcement, and the discretion to design a program specific to their individual institution. If FinCEN does not adopt these changes, it risks rewriting the statute and undercutting Congress's core message from the AML Act of 2020.
• Focus on the big picture and rethink prescriptive timelines. The proposal requires banks to update their risk assessment based on opaque timelines and triggers such as "on a periodic basis" or whenever there are "material changes." This creates confusion for banks and regulators and perpetuates the misguided notion that banks employ only a single assessment. The reality is that banks employ multiple assessments. FinCEN should allow banks to focus on the big picture rather than compliance with a prescriptive requirement. "Material change" should be clearly defined as changes triggered by the most significant risks and periodic updates should be left to the banks' discretion.
• Allow banks to deploy additional resources, where most effective and efficient. Banks should be encouraged to continue to leverage offshore personnel to carry out U.S. AML/CFT functions so long as the bank's chief program officer for the U.S. AML/CFT program is domestic and subject to U.S. jurisdiction and oversight.
• Set a realistic implementation timeline: Extend the implementation timeline from six months to at least two years to accommodate necessary updates to trainings, processes and controls.

3. The Benefits of Avoiding Basel and Stress Test Capital Requirements

A Bloomberg article this week paints a vivid picture of who stands to benefit from subjecting banks to uneconomic capital requirements. "Citadel Securities and Jane Street Group LLC, two of the largest market-making firms in the US, are on track for record annual revenue hauls as they further encroach on the big banks' trading territory," the article states. "First-half net trading revenue rose 81% to $4.9 billion from the same period a year earlier at Citadel Securities, and gained 78% to $8.4 billion at Jane Street, according to people familiar with the matter, both well ahead of the pace needed for an all-time high annual total. The results offer a rare glimpse into the closely held firms, which have been investing in technology and talent to steadily expand their market-making capabilities in equities and fixed-income trading across the globe."

4. Hsu's Recent Speech: 'DSIB' Label, Cyber Contradictions

OCC Acting Comptroller Michael Hsu suggested in a speech at a European conference this week that the "time may be ripe for the U.S. banking agencies to consider a framework for formally identifying domestic systemically important banks," or "DSIBs." Hsu was referring to large regional banks, saying that the OCC "must ensure that [its] supervision and regulation of non-G-SIB large banks are not under-calibrated." The remarks came as GSIB-like requirements, from proposed long-term debt requirements and capital charges to new resolution planning requirements, are already hanging over regional banks and threatening to reverse regulatory tailoring.

• Supervision: Hsu made several observations on bank supervision, calling for a "team-of-teams approach" to overseeing the largest global banks and an embrace of "risk-based supervision" over a check-the-box focus on process.
• Cybersecurity: Hsu attributed banks' resilience to the ripple effects of the CrowdStrike outage to the OCC's supervisory efforts. A perplexing footnote in the speech however cited that 33 percent of large OCC-supervised banks and 3 percent of community banks have an adverse rating. These figures appear to contradict banks' performance in the face of market events and the benefits of scale in IT and cybersecurity infrastructure.

5. FDIC Brokered Deposit Measure Would Reverse Recent Changes

The FDIC's brokered deposits proposal issued on Aug. 30 would mark a step backward, reversing several important changes the agency implemented in 2020. The new proposal would broaden the types of deposits considered "brokered," which could increase costs and lead to changes in how customers access financial services. BPI and a broad coalition of other trades called on the FDIC in a letter to withdraw the proposal, or otherwise to provide data and grant an extension of the comment period.

• More analysis needed: Classifying deposits as brokered would impose costs that do not align with the risks of different funding types. "This is particularly troubling given that Section 29 [of the Federal Deposit Insurance Act] was intended to restrict the weakest banks from seeking deposits by paying higher-than-market interest rates, not to discourage healthy banks from holding a diverse funding mix or meeting the needs of their customers in a modern banking environment," the letter states. The letter encourages the FDIC to consider revisions to the brokered deposits rule only after providing sufficient data and analysis to support any changes and after providing the public an opportunity to comment on that data.
• Deposit data gathering: On a separate measure - an FDIC request for information to gather data on characteristics of different types of deposits - BPI and a group of trades also requested an extension of the comment period by 60 days, as the current deadline would not be sufficient time to provide comments on the wide-ranging topics addressed in the FDIC's request.

In Case You Missed It

TikTok Check Fraud Brigade Is Actually Just Full of Brazen Criminals

In a National Review article, Charles C. W. Cooke responds to a recent media piece on the TikTok controversy of check fraud-it's crime, plain and simple. Cooke dismisses the notion that perpetrators may not understand check fraud because they're unfamiliar with writing checks. "No, the people who did this cannot "probably be forgiven" - for anything … it doesn't matter whether the people who engaged in this behavior understood the ins and outs of checks, or of ATMs, or of any other aspect of banking, and it doesn't matter whether or not those people had enjoyed sufficient "financial literacy education." This wasn't an example of bad decision-making as the result of a lack of information, or of incomprehensible complexity screwing over otherwise decent people; it was a brazen attempt to steal money that the thieves knew full well was not theirs. This was larceny. It was deliberate, conscious, willful larceny. That most of the people who engaged in it "have probably never written a check in their lives" does nothing to alter that."

Paper by BPI's Nelson Published in Southern Economic Journal

A paper by BPI Chief Economist Bill Nelson was published this week in the Southern Economic Journal. The paper, "How the Federal Reserve Got So Huge, and Why and How It Can Shrink," was also published in February 2024 as a BPI staff working paper here. In the paper, Nelson describes the Fed's evolution from a monetary policy framework using only the necessary level of reserves to its current excessive-reserves framework. For decades, the Fed borrowed from banks only the amount of reserve balances - banks' deposits at the Fed - that the banks considered necessary for payment purposes and to satisfy reserve requirements. But in the wake of the Global Financial Crisis, the central bank shifted to borrowing more reserves than banks needed to satisfy reserve requirements and payment clearing needs. As Nelson details, this fundamental change in approach has led to a sprawling balance sheet, a dried-up interbank lending market and a massive central bank entangled in the economy. Furthermore, the excessive-reserves system has not produced its purported benefits, according to the paper. Nelson describes how the Fed can shrink and return to normal without causing market turmoil.

FHFA Watchdog Flags Problems Laid Bare by 2023 Bank Turmoil

The Office of Inspector General for the Federal Housing Finance Agency identified pitfalls at the agency exposed by the 2023 bank failures. The report, released in August, flagged FHFA's flawed examination of Federal Home Loan Bank risk management regarding member collateral. Among the issues highlighted in the report:

• FHFA failed to issue written guidance on FHLB practices on the banks subordinating their security interests in members' collateral when needed to allow the members access to the Fed's discount window.
• FHFA lacked internal written guidance to inform coordination with other regulators during the bank failures.
• FHFA has not revised relevant examination guidance since 2014; current guidance does not address the risks that resulted in the bank failures.
• FHFA lacks a practical approach for ensuring that all topics covered by examination guidance are reviewed by examiners. This means that risks may be overlooked.
• The report recommended that FHFA develop new protocols to follow in bank distress and failures. It also recommended that the agency's examination manual should incorporate topics related to the bank failures, and that FHFA "issue written guidance on the FHLBanks' collateral subordination practices."

The Crypto Ledger

Here's the latest in crypto.

California fines Robinhood: Trading platform Robinhood's crypto unit faces a $3.9 million fine from the state of California, the culmination of a state probe into the app's past practice of preventing customers from withdrawing tokens they bought.

Uniswap settlement: The CFTC this week settled charges against crypto firm Uniswap Labs, which was accused of illegally offering leveraged or margined retail commodity transactions in digital assets via a decentralized digital asset trading protocol. The company must pay $175,000 in civil monetary penalties, according to the CFTC.

CBDC lit review: An ECB staff working paper reviewed the literature on central bank digital currency, suggesting that "macroeconomic models of CBDC often rely on CBDC design features and narratives which are no longer in line with the one of central banks actually working on CBDC." In particular, the authors state, the literature does not take into account the nature of central banks' plans to issue CBDC as a "conservative" reaction to major technological and other shifts in the use of money for payments; it also does not start from design features specified by central banks such as quantity limits or access restrictions; it does not explain sufficiently the difference between CBDC and banknotes within their macroeconomic models; assumes that CBDC will lead to a marked increase in total holdings of central bank money in the economy.

Barclays Appoints Leonhardt as Global Head of Retail within Investment Banking

Barclays this week announced the appointment of Cathy Leonhardt as Global Head of Retail within Investment Banking. She will be based in New York, and will report to Lowell Strug, Global Head of Consumer and Retail Group. Leonhardt joins Barclays from Solomon Partners, where she served as a Partner and Co-Head of Consumer Retail Investment Banking.