BPInsights: Dec. 14, 2024

The Truth About Account Closures

Recent discussions about "debanking" have put new focus on law-abiding businesses that report challenges accessing banking services, but alleviating this issue requires a closer look at inefficient regulatory requirements and the opaque bank examination regime.

State of play: Banks play a crucial role in detecting and reporting suspected financial crimes. They dedicate immense resources to preventing terrorists, drug traffickers and other criminals from exploiting the U.S. financial system. But regulatory requirements and examiners' approaches for preventing these activities are inefficient and largely ineffective, leading banks to file millions of Suspicious Activity Reports and ultimately designating some customers as "high risk" even if they are not breaking the law. Improving this framework would benefit both law enforcement and law-abiding customers by allowing banks to focus on the highest-risk transactions and more accurately identify criminal activity.

• The bank examination system gives banks strong incentives to file SARs; banks fear penalties even for inadvertently missing criminal activity, but will never be punished for filing too many SARs.
• SARs are confidential and prohibited by law from disclosure. This means if a SAR is involved, banks may not be able to disclose much, if anything, to the customer about the reasons for the closure.
• Examiners can also require banks to designate certain accounts as "high risk." Although there are good reasons to do so in some cases, an overly broad and punitive approach can significantly raise the costs to the bank and increase the risk of regulatory penalties, leading to reduced services for even law-abiding customers. Banks have paid penalties of hundreds of millions or even billions of dollars in recent years for failing to close an account or terminate a customer relationship with high illicit finance risk, even when the risk was only clear with the benefit of hindsight.

Context: Crypto firms are the latest group raising concerns about access to banking services, but similar issues have been around for decades.

• Customers from various geographies and industries have raised concerns over the years that "derisking" to mitigate BSA/AML risk, as well as regulators' scrutiny of "reputational risk," have limited their access to banking services.
• More recently, issuances from the banking agencies indicate particular scrutiny on crypto activities at banks, such as banks needing to seek prior approval from regulators before engaging in such activities.

Shrouded from view: Some banking agency guidance says banks are neither prohibited nor discouraged from providing any legal banking services, but in practice, the secret examination regime gives regulators an effective veto over a bank's activities. This opaque supervision function is the invisible chain binding banks' business decisions, in combination with an AML regime that prizes compliance checklists over precision.

• Recent supervisory letters obtained by Coinbase and History Associates, Inc. show this phenomenon in action. The 23 supervisory letters are heavily redacted but they reveal examiners "requesting" that banks "pause" crypto-related activities, describe numerous conference calls and exchanges of information between banks and examiners, and include lengthy lists of questions regarding banks' planned crypto-related services. These letters provide a rare glimpse into how examiner pressure can discourage activities, even if they are legally permitted.

Solutions: Policymakers under the next Administration can and should address these problems.

• They can reform anti-money laundering oversight and allow banks to focus on the highest-risk transactions. They should faithfully implement the Anti-Money Laundering Act of 2020, rewrite the related FinCEN proposal to reflect the risk-based, effective AML approach espoused by that statute and overhaul the SAR regime.
• More broadly, they can reform the broken bank examination regime, eliminating backdoor levers that tell banks how and with whom to do business.

Five Key Things

1. Trump: No Plans to Fire Powell

President-elect Donald Trump said earlier this week he had no plans to dismiss Fed Chair Jerome Powell. "Meet the Press" host Kristen Welker asked Trump if he planned to ask Powell to resign, and Trump responded, "No, I don't." Media reports have raised the prospect of Trump trying to remove the Fed chair before his term is complete, but Powell has said such an action is not permitted under the law.

2. Federal Reserve Financial Stability Report Confirms Concerns About Treasury Market Liquidity

The Federal Reserve's latest Financial Stability Report expressed concern about diminished liquidity in the Treasury market. "Various measures of market liquidity, such as market depth, suggest that liquidity in the Treasury cash market remained low by historical standards, especially in the on-the-run segment … Overall, liquidity conditions in the Treasury cash market appear challenged and could amplify shocks," the report said.

• The binding constraint: The report acknowledges concerns about dealers' capacity to intermediate in the crucial market. However, it blames that lack of capacity entirely on internal risk limits rather than bank regulatory factors, such as the supplementary leverage ratio: "… during periods of market stress, broker-dealers may not be able to meet increased intermediation demand, as their capacity to intermediate may become reduced due to internal risk limits, a factor that has been a structural vulnerability for the Treasury market."
• Digging deeper: The relationship between cause and effect in the Treasury market's strains is complex, and policymakers may risk inflicting further damage if they misdiagnose the factors at play. Even if internal risk limits are a binding constraint at some banks at some times, the limits would be proportional to the capital that banks allocate to a certain business line, and decisions to allocate capital to certain business lines over others are driven partly by capital regulation. The implication of internal risk limits being a vulnerability also raises questions - does this suggest that policymakers find such limits undesirable?

3. CFPB Issues Overdraft Rule

The CFPB on Thursday issued a final rule on overdraft fees. The rule would offer a three-pronged approach: Banks can cap overdraft fees at $5; the amount that covers a bank's costs and losses, for "banks that wish to offer overdraft as a convenient service rather than as a profit center"; or disclose the terms of their overdraft loan "just like other loans" for "banks that wish to profit from overdraft lending." Later on Thursday, a group of financial trades led by the Consumer Bankers Association filed a legal challenge against the rule. "The Final Rule purports to rely primarily on the Truth in Lending Act ("TILA"), a statute regarding disclosure obligations for credit products, to impose an expansive and complex new regulatory regime on overdraft services offered by large financial institutions, replete with de facto price caps and significant restrictions on the terms under which the services can be offered," the lawsuit says. "But TILA in no way supports the Final Rule."

4. The NGFS's New Climate Damage Function: A Flawed Analysis With Massive Economic Consequences

A key element of a global central bank consortium's climate risk analysis aims to project damage to global real income due to climate change effects. The metric is the Network of Central Banks and Supervisors For Greening the Financial System's "damage function." The new damage function is a flawed model that could lead to unnecessarily higher capital requirements, posing a risk to economic growth.

Background: The Network of Central Banks and Supervisors for Greening the Financial System, or NGFS, is a consortium of central banks and financial regulators. The U.S. is represented in this supranational body by the Federal Reserve, OCC, FDIC and FHFA. The NGFS develops climate scenarios used to measure the banking system's resilience to climate risks, such as rising temperatures or floods. The Fed used NGFS climate scenarios in an exercise last year for large U.S. banks, and the ECB has done similar exercises.

What's happening now: In November, the NGFS updated its "damage function", a part of the climate scenario that projects the effects of rising temperatures and other climate risks on global real income. The updated damage function was based completely on one academic paper published this year.

• The updated damage function predicts that global real income will be 19 percent lower by 2050 than it would have been with no climate change, regardless of whether current carbon emission trends improve or worsen. The damage function projects 60 percent lower global real income by 2100 if current emission trends worsen.
• These extreme economic assumptions in the scenarios would be used in banks' climate stress tests, practically ensuring that those tests will conclude that all global banks face material climate risks that would require higher capital levels.

Unfounded: BPI's new analysis reviews the updated damage function and finds no basis for its projections. The model relies on an arbitrary statistical procedure that could easily have predicted much smaller losses of income due to climate change effects. BPI's analysis found very limited statistical evidence for any causation between the climate variables and material economic damage and no statistical evidence for the purported influence of the temperature variables that drive almost all the economic damage.

Beware of uncertainty: The findings of BPI's analysis align with the current state of academic research on damage functions - highly uncertain and lacking consensus. It's unclear why the NGFS would adopt the results of a single academic paper, especially given the massive ramifications for global economic growth.

• The data on damage functions is still too uncertain to designate one damage function as clearly superior to many alternatives. Instead, any new damage model should be specified as a hypothetical scenario assumption rather than an empirical fact. The NGFS could use a range of models to incorporate different assumptions into its scenarios, as long as they are well-tested and plausible. The organization should use an open process with extensive member review, subject to public comment, before any new damage models are adopted.

5. To Improve the Discount Window, Make It More Ordinary, Transparent and Efficient

As the Fed aims to improve its discount window, a key source of contingency funding, it should harmonize and modernize its operations, increase its transparency and encourage bank readiness to use the window in more ordinary circumstances, BPI said in a comment letter this week. The Fed's effort to seek public input on this issue is an encouraging step forward in addressing the window's challenges.

What BPI is saying: "We welcome the Fed's efforts to make the discount window a more effective tool to support financial stability. The banking turmoil of 2023 made it clear that ensuring the window is ready and efficient to use is an urgent priority. It's critical that new improvements cement the window as an ordinary liquidity tool rather than a disparaged and disused emergency lever. Regulators should also consider changes to the window not in isolation but in the context of liquidity requirements."
- Brett Waxman, BPI SVP and senior associate general counsel

Background: The Fed is seeking feedback on the discount window's "operational effectiveness" as it considers potential improvements. The window has long suffered from clunky infrastructure and is known to have significant stigma attached to its use; as a result, banks may have been unwilling or unable to use it in a liquidity crisis, as in the bank failures of 2023.

4 key focus areas: To improve the discount window, the Fed should focus on four main objectives:

1. Harmonizing operational practices across Reserve Banks.
2. Improving transparency about which collateral is eligible for being used in discount window borrowing and how it is valued.
3. Modernizing operational processes.
4. Encouraging bank readiness to borrow.

Big picture: Potential discount window reforms are only one element of a broader rethinking of the liquidity framework that should be considered by the banking agencies, along with efforts to reduce associated discount window stigma. The agencies should take into account discount window availability in liquidity requirements, such as the liquidity coverage ratio internal liquidity stress tests, and examiners should take it into account when evaluating banks' liquidity and funding.

What is screen scraping? And why is it a risk to consumers' data? Watch this new video to learn more.

In Case You Missed It

Rep. French Hill Tapped to Lead House Financial Services Committee

Rep. French Hill (R-AR) was selected Thursday to lead the House Financial Services Committee as chair during the next Congress. Hill previously served as vice chair of the panel under departing Chair Patrick McHenry (R-NC) and led the Subcommittee on Digital Assets, Financial Technology and Inclusion. A former community banker, Hill is known for looking to reduce regulatory burdens on the banking industry while also being one of the main thought leaders on the Hill regarding digital assets policy.

Tech, Supervision and Credit Cards: Highlights from the Senate CFPB Hearing

The Senate Banking Committee this week held a hearing with CFPB Director Rohit Chopra. Rules on medical debt, data brokers and digital wallets were among the topics of discussion. Here are some highlights.

• Tech oversight: CFPB oversight of Big Tech emerged as a topic at the hearing. "We've shifted our supervision away from many of the banks and toward the biggest nonbanks who touch almost every wallet in our country," Chopra said. The CFPB has recently taken steps to directly supervise large tech firms that have payments businesses. Google recently filed a lawsuit challenging such actions.
• Cost-benefit analysis: Sen. Thom Tillis (R-NC) pressed Chopra on the thoroughness of the CFPB's cost-benefit analysis, an issue that has marred rulemakings at the prudential regulatory agencies.
• 'Debanking': Sen. Tim Scott (R-SC), ranking member and incoming chair of the panel, addressed the issue of "debanking" generally in his opening statement and said that the committee will look to address it in the coming months; however, the self-proclaimed efforts by Chopra to deal with debanking wouldn't address the issue and Scott stated they didn't see Chopra as an ally on this issue.
• Timing: Scott urged Chopra to resign from his position as of Jan. 20. Chopra said: "As you know, we serve and are confirmed for a five-year term. The President can remove us at any time, any day, and we obviously completely respect that right." The President's ability to dismiss a CFPB director at will was cemented in a Supreme Court ruling in the Seila Law case. Scott also pressed Chopra to pause rulemaking until the new year, which the prudential regulators had said during a recent Congressional hearing that they would do. (The CFPB issued a significant new rule the next day.)
• Jurisdiction: Scott questioned if the CFPB is failing in "doing the basic jobs it was created to do as part of Dodd-Frank" - acting as primary supervisor of compliance with consumer financial laws for banks above a certain threshold. Scott referred to a recent CFPB inspector general report that found the agency had not completed such supervision transitions in a timely manner.
• Interest rate cap: Sen. Elizabeth Warren (D-MA), the incoming ranking member of the panel, asked Chopra if the CFPB has the authority to enforce a proposed 10 percent cap on credit card interest rates floated by President-elect Trump. "We certainly have the capacity to enforce it," Chopra said.

BPI Survey of Bank Treasurers on Willingness and Perceived Ability to Borrow from Fed Lending Facilities

BPI recently conducted a survey of large bank treasurers on the banks' willingness to use the discount window or standing repo facility and on banks' interpretations of the rules for required internal liquidity stress tests. After the bank failures of 2023, the Fed has been working to increase banks' willingness to borrow from its discount window and standing repo facility. As part of the effort, it recently clarified the rules for large banks' internal liquidity stress tests. BPI's treasurer survey, with 31 respondents, shows that there has been some progress in the Fed's discount window efforts, but suggests that further work remains necessary.

The questions covered the following topics:

• Banks' willingness to use the discount window and standing repo facility
• Banks' demand for reserve balances
• Banks' understanding of the rules governing internal liquidity stress tests.

The results: The Fed's efforts appear to be making a difference, but there's more work ahead. A quarter of treasurers indicated that their bank was at least somewhat more willing to borrow from the discount window than they were a year ago, and one third indicated they were more willing to borrow from the standing repo facility. While banks have become a bit more willing, banks' overall willingness remains extremely low.

• Why? Treasurers gave various reasons for an increased willingness to use these facilities. On the discount window, treasurers pointed to the Fed's clarifying new FAQ document, public comments from Fed officials and encouragement by examiners as key reasons driving their greater willingness. On the SRF, banks pointed to the FAQ, changes in senior bank management views and Fed officials' public comments.
• More clarity needed. Bank treasurers have a range of views about what, exactly, the Fed's FAQ on internal liquidity stress tests means, suggesting that further clarification may be needed.

Other highlights:

• Most banks indicated that their plans for Federal Home Loan Bank advances as a source of contingency funding were unchanged, but one quarter indicated that they scaled back their planned use.
• The Fed appears to be trying to convince banks that they do not need such large stockpiles of reserve balances. However, more than twice as many banks in this survey stated that their demand for reserves had gone up rather than down.

What's Keeping Financial Regulators Up at Night? Fed, FSOC Offer Glimpses

The Federal Reserve's Financial Stability Report and the Financial Stability Oversight Council's Annual Report for 2024 offer views into the concerns and risks at the top of financial regulators' priority list. The FSOC report gives a final glimpse of such concerns under outgoing Treasury Secretary Janet Yellen. Here are a few highlights.

• Treasury market: As outlined separately above, the Fed's report details concern about liquidity in the Treasury market and flags reduced dealer intermediation capacity as a worry, although it attributes this lower capacity to internal risk limits rather than regulation that constrains' banks market-making. The FSOC report states that despite several episodes of "abrupt deterioration in market functioning" in recent years, the Treasury market's liquidity was resilient through interest rate volatility in 2024. It refers to an interagency working group's efforts to improve the Treasury market and praises the SEC's finalization of a rule expanding central clearing of Treasuries. FSOC flagged concern about increased leverage in the Treasury market, particularly surrounding the "basis trade."
• High-level view: The FSOC report identifies several high-level risk areas, such as office real estate loans, nonbank firms such as private credit and nonbank mortgage lenders, volatility in short term funding markets, stablecoins, climate risk and cybersecurity. Both reports characterized the banking sector as sound and resilient, and several of these risks, such as cyber risk, were highlighted in both reports. Near-term risks to the financial system highlighted in the Fed's stability report included U.S. fiscal debt sustainability, the top-cited risk; Middle East tensions; policy uncertainty; a U.S. recession; and persistent inflation and monetary tightening.
• Stablecoins: FSOC called for Congress to pass legislation creating a federal prudential oversight framework for stablecoins. If legislation is not enacted, FSOC will stand ready to consider how to address risks related to stablecoins, the report says. The Fed's report also flags stablecoins as a concern, saying they have grown substantially and remain vulnerable to runs.

Watchdog Flags FDIC's Flawed Approach to Resolving Regional Banks

The FDIC Office of Inspector General this week released a report flagging several deficiencies in the regulatory agency's resolution of regional banks. The report evaluated the FDIC's resolution ability before the 2023 failures of Silicon Valley Bank, Signature Bank and First Republic, but the watchdog office said it would release a subsequent report addressing the resolution issues related to those banks. The issues highlighted in this report likely laid the groundwork for the FDIC's failures in the SVB and Signature resolutions - problems that BPI urged the OIG to investigate in July. The assessment laid out consequential problems in the area of large regional bank resolution: "Unless the FDIC obtains, maintains and coordinates the resources needed to improve its readiness capabilities to respond to future large regional bank failure scenarios, it risks further strain on its staff and on divisional relationships, as well as reputational harm should there be a loss of public confidence in the banking system," the report said. In this week's report, the inspector general concluded that:

• The FDIC did not allocate enough resources to preparing for large regional bank resolutions.
• FDIC internal procedures for executing large regional bank resolution "contained significant gaps."
• The FDIC's readiness to resolve large regional banks under the Federal Deposit Insurance Act was not sufficiently mature to facilitate consistently efficient response efforts in a potential crisis failure environment.
• At the time of the spring 2023 failures, the FDIC had not ensured that it fully met human and technology resource needs or that it sufficiently coordinated resources among its divisions and offices.
• The FDIC did not employ best practices for planning, training, exercises, evaluation and monitoring.

The report made 11 recommendations to the FDIC to improve its readiness to resolve large regional banks. To read the report, click here.

Bank of England Seeks Input on Move to 'Repo-Led Operating Framework'

The Bank of England this week published a discussion paper seeking public input on its transition to a new system for supplying reserves to the banking system. The new system will be "repo-led" and "demand-driven" - a system that supplies the banking sector's demand for reserves, but no more than that, and uses regular, flexible lending operations to address fluctuations in the demand for liquidity. This design will play an important role in the size of the Bank's balance sheet after it unwinds its asset purchase program. The new approach compares to a supply-driven framework used over the last decade, which supplied the market with "abundant" reserves through asset purchases and other actions. In sum, the Bank is moving from a floor system, in which it oversupplies reserves, to a ceiling system, in which it undersupplies reserves and banks, in aggregate, borrow from the BoE to make up the difference.

• Changes afoot: The process of transition from a supply-led to demand-led approach has begun, noted Vicky Saporta, the BoE's Executive Director of the Markets Directorate. Reserves are steadily falling, and use of the Bank's Short-Term Repo and Indexed Long-Term Repo facilities is rising. Supplying reserves through repo operations against a broad set of collateral will require banks to make a "substantial change" in how they manage their liquidity and interact with the central bank, according to the paper. Saporta outlined the upcoming changes in a speech earlier this year entitled "Let's Get Ready to Repo!"
• Key goal: "The primary aim of this discussion paper (DP) is to set out to market participants how we envisage our overall demand-driven, repo-led framework for supplying reserves will operate, and to seek feedback on its calibration as we continue this transition," the paper said.
• Highlights: The ILTR facility, one of the BoE repo facilities mentioned in the paper, will play a greater role than it has in the past; along with its short-term counterpart, it will supply the majority of the stock of reserves to meet the banking system's liquidity needs. "The ILTR's parameters need to adapt to this evolving role, and one key purpose for this discussion paper is to set out those revised parameters," the paper states.
• Questions under consideration: The paper seeks feedback on questions including: potential operational barriers for banks and other participants; how the ILTR is recalibrated; how participants view usage of the facility relative to private market alternatives; and how users may split their usage between the short- and long-term facilities.
• Slightly confusing: Under the new BoE implementation framework, the reserves demanded by banks in aggregate will be created in large part and at the margin through loans from the BoE to banks in the form of term repos, but there need not be any correspondence between any individual bank's holding of reserves and its borrowing from the BoE.

Fed's Senior Financial Officer Survey Gives Window Into Bank Managers' Views

The Federal Reserve published its survey of Senior Financial Officers on Friday. The survey, conducted in September 2024, questioned bank financial managers about demand for reserve balances and views on the discount window, among other topics. The SFOS found that banks' demand for reserve balances was unchanged or higher. In addition, the survey found that most banks were highly unwilling to borrow from the discount window. A recent BPI survey, conducted two months later, highlighted above found modest but noticeable progress in bank officials' views on the window, although more work needs to be done.

• Balance sheet growth: About one-third of respondents indicated that their bank expects to take actions intended to increase, or limit the decline in, the size of its balance sheet and around one-third of respondents indicated that their bank expects to take actions intended to maintain the current size of its balance sheet, according to the survey.
• Discount window: Respondents to the survey, on average, reported that their banks would be somewhat unwilling to borrow from the Fed's discount window in several scenarios. Banks were most willing to borrow in the two scenarios where other funding sources became more expensive than the primary credit rate due to firm-specific stress or due to marketwide stress.
• Operational hurdles: Respondents were asked to elaborate if they responded that steps associated with the discount window or Fed intraday credit were burdensome. Of respondents who provided an answer, just less than half mentioned various aspects of the process for pledging or withdrawing loans as collateral. Some respondents also characterized submitting legal documents to their Federal Reserve Bank as a burdensome process. BPI submitted a letter on Monday in response to the Fed's request for information on how to improve discount window operations, available here.

Read the full survey here.

FSB Makes Recommendations on Data Flows, Cross-Border Payments Oversight

The Financial Stability Board this week issued recommendations on data flows related to cross-border payments. The recommendations aim to "promote a level playing field between bank and non-bank providers of payment services." They are part of the FSB's efforts to meet the goals of the G20 cross-border payments roadmap, a strategy in this area. The organization is establishing a new Forum on Cross-Border Payments Data to advance work on these recommendations. That group will be comprised of "public-sector stakeholders covering payments, anti-money laundering and countering the financing of terrorism (AML/CFT), sanctions, and data privacy and protection." The Forum will also establish a private sector advisory group. The recommendations cover four broad categories:

• Addressing uncertainty about how to balance regulatory and supervisory obligations
• Promoting the alignment and interoperability of regulatory and data requirements related to cross-border payments
• Mitigating restrictions on the flow of data related to payments across borders
• Reducing barriers to innovation

To read the full recommendations, click here.

Basel Committee Issues Guidelines on Bank Counterparty Credit Risk Management

The Basel Committee on Banking Supervision this week issued final guidelines on banks' counterparty credit risk management. The measure includes guidelines on key practices meant to address weaknesses in CCR management, including the need to conduct comprehensive due diligence at the beginning of a counterparty relationship and on an ongoing basis, to develop a comprehensive credit risk mitigation strategy to manage counterparty exposures effectively and to build a strong governance framework.

Context: The BCBS cited "recent events, such as the default of Archegos Capital Management" as highlighting vulnerabilities in this risk management area. "These issues are particularly acute for high-risk counterparties, such as institutions with material concentrations, opaque business activities, limited transparency or high leverage." The guidelines build on a BCBS consultation from earlier this year and replace a best practices document published in 1999.

Context: The BCBS cited "recent events, such as the default of Archegos Capital Management" as highlighting vulnerabilities in this risk management area. "These issues are particularly acute for high-risk counterparties, such as institutions with material concentrations, opaque business activities, limited transparency or high leverage."

The Crypto Ledger

Here's what's new in crypto.

• CBDC for cross-border payments: Central bank digital currency appears to be waning as a proposed solution to cross-border payments woes. Only 13 percent of central banks said connecting to CBDC is best for cross-border payments, compared to 31 percent in 2023, in a survey cited ahead of the Future of Payments conference.
• Where in the world is Binance based? Crypto exchange Binance, whose former CEO Changpeng Zhao pleaded guilty to U.S. money laundering violations this year and served time in prison, has still not decided where to base its global headquarters, according to Reuters this week.

Goldman Sachs' Solomon on Basel's Path Forward

Goldman Sachs CEO David Solomon participated in a Q&A session during this week's Reuters NEXT conference. Solomon discussed a range of topics, from the Trump Administration's potential economic impacts to bank regulation. On Basel Endgame, he said: "It's going to be important in the course of the next few years that we find a path to closing out Basel III," referring to the international agreement. "I'm confident that, as we move forward, we'll find an appropriate path, working with the regulators to get to the right place." Solomon mentioned the broad range of commenters who pushed back on the U.S. Basel proposal, far beyond the financial industry.

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