BPInsights: April 27, 2024

Stress Testing Framework Needs More Transparency

The failure of Silicon Valley Bank in March 2023 highlighted the need to incorporate scenarios that account for rising interest rates. In response, the Fed introduced "exploratory" scenarios in the 2024 stress tests to complement the severely adverse scenario and include a broader range of potential economic outcomes.

Following the Fed's map: This note focuses on the importance of transparency in the stress testing process, particularly in the projections of net interest income, which are highly sensitive to changes in interest rates. This year's exploratory scenarios in the stress tests aim to gauge large banks' resilience to interest rate risk. However, rising rates typically benefit banks by increasing their net interest income. This contradiction underscores the need for the Fed to enhance transparency.

• A notable gap: The Fed's methodology lacks sufficient disclosure of assumptions, parameters and adjustments used in their models, making it difficult to fully replicate and assess the validity of the projections in prior year's stress tests.
• Funding shocks: The funding shocks incorporated into the 2024 stress tests appear to lack a coherent and well-defined standard. The scenario includes several concerning elements, such as the assumption that deposits would instantly shift as rates rise, and the failure to account for differences in banks' specific business models.

What's at stake: The Fed's stress tests are a cornerstone of the bank capital framework. They determine how much capital banks must maintain and, therefore, drive the cost of doing business for large banks in the U.S. and, ultimately, the cost of credit for their customers. To improve the robustness and comparability of the stress testing results, the Federal Reserve should develop a more refined and standardized approach to modeling funding shocks, ensuring a clear link to the macroeconomic scenarios. Furthermore, the Fed should increase transparency by sharing more information about the underlying assumptions and methodologies employed. All these changes should be subject to public notice and comment.
By addressing these issues, the Fed can enhance confidence in the stress testing framework and provide a more accurate assessment of banks' resilience to a broader range of risks. Without fully credible, robust and transparent models, the stress test results could depict an unrealistic portrait of risk.

Five Key Things

1. Here We Go Again: Regulators Versus The Law on Bank Compensation

Recent news reports suggest that some federal financial regulators plan to move forward without the Federal Reserve to revive a 2016 proposal on incentive compensation restrictions. Although cutting banker pay makes enticing political headlines, the earlier proposal far exceeded what Congress actually authorized the regulators to do.

• Perspective: The compensation limits reportedly under consideration would apply to banks but not to hedge funds, private equity or debt funds, payday lenders, fintechs or the other financial firms that control more than half of U.S. financial assets. No other industry, from pharmaceuticals to aerospace, has its senior staff's pay dictated by the government. The implications for recruiting qualified managers and senior experts are alarming.
• Congressional context: Perhaps it was because of such concerns that Congress never authorized the agencies to propose prescriptive compensation rules. It told them to identify bad incentive compensation practices that could lead to material financial loss. The agencies appear to have taken that as a mandate to impose their own government-devised plan for executive compensation.

A new BPI blog post lays out the law versus the past and likely forthcoming proposal.

2. WSJ: Move Aside, Big Banks: Giant Funds Now Rule Wall Street

The shape of the financial system is changing, and banks are increasingly relegated to the margins of it, the Wall Street Journal reported this week. Asset managers - both traditional and alternative - now control twice as many assets as U.S. banks, according to the article. These asset managers are selling products not only to wealthy clients but also to average mom-and-pop investors. Lines are blurring between the services that regulated banks provide and the "financial supermarket" of products and services offered by their nonbank counterparts.

• Key quote: "Top firms now control sums rivaling the economies of many large countries. They are pushing into new business areas, blurring the lines that define who does what on Wall Street and nudging once-dominant banks toward the sidelines."
• What's next: This push will only accelerate if regulators adopt significant capital requirement increases, a long-term debt requirement and other changes. The question policymakers must ask is, where does that leave consumers?

3. U.S. Mulling Sanctions on Chinese Banks that Finance Goods that Help Russia in War

The U.S. is targeting Chinese banks with potential sanctions in the hope of discouraging China from supporting Russia's military production in the war against Ukraine, according to the Wall Street Journal. The sanctions would take aim at banks serving as key intermediaries for commercial exports to Russia that have military uses, handling payments and providing trade credit. The news report came as Secretary of State Antony Blinken headed to Beijing this week. "U.S. officials say targeting banks with sanctions is an escalatory option in case the diplomatic overtures fail to persuade Beijing to curb its exports," according to the article.

• Broader context: U.S. sanctions have emerged in recent years as a key tool in geopolitical conflicts. The threat of losing access to U.S. dollars and the American banking system can serve as a persuasive motivation. Cutting banks off from access to the dollar has much broader implications than normal sanctions targeting individuals and firms, and so are often reserved as a last resort. Amid the proliferation of sanctions in the last decade, banks have called for sanctions screening methods to move toward a risk-based approach, where the highest-risk transactions take priority.

4. FDIC Eyes Scrutiny of Large Asset Managers' Bank Stakes

Members of the FDIC this week floated, but ultimately did not vote on, new proposals that would enhance scrutiny of large funds holding investment stakes in banks. The FDIC adjourned its board meeting without holding a vote to advance the measures after OCC chief Michael Hsu, an FDIC board member, said he would oppose them. One measure, spearheaded by board member Jonathan McKernan, would ramp up monitoring of asset managers' "passive" investments. Another measure backed by CFPB director and FDIC board member Rohit Chopra would aim to empower the FDIC to block investment companies from taking large stakes in the parent companies of state-chartered banks, according to Bloomberg.

5. France's Marcon: Europe Should Revise Capital Rules Approach

French President Emmanuel Macron called in recent remarks for a revamp in how Basel bank capital rules - and EU rules for insurers known as Solvency II - are applied. "We need to revise how Basel and Solvency are applied," Macron said in a Paris speech. "We cannot be the only economic zone in the world that applies them." He further stated: "I am not in favor of removing everything, I don't want to return to a culture of financial recklessness. I just want us to put some risk culture back in the way we manage savings." French policymakers are concerned about a lag in Basel implementation between the EU and the U.S. that could put Europe at a competitive disadvantage.

In Case You Missed It

EBA Chief: Europe Prepared in Case of U.S. Basel Delays

José Manuel Campa, head of the European Banking Authority, said in a recent POLITICO interview that the EU is prepared in the event that the U.S. or the UK delays implementation of Basel rules. The EU will consider what it has "to do going forward, if there were to be delays in implementation, either by the U.S. or the U.K.," he said. "We will make sure that there is consistent implementation across the world, so as we go forward, if that consistent implementation gets questioned at some point or gets in danger, we'll have to manage that," Campa said.

The Crypto Ledger

Here's the latest in crypto.

• Another crypto king jailed? The U.S. Department of Justice recommended a three-year prison sentence for former Binance CEO Changpeng Zhao, who pleaded guilty last year to failing to maintain an effective anti-money laundering program at the crypto exchange. Binance pleaded guilty to U.S. anti-money laundering and sanctions violations.
• SEC resignations: Two SEC attorneys, Michael Welsh and Joseph Watkins, resigned this month after a judge rebuked the agency for "gross abuse" of power in a crypto enforcement case, including alleged false statements, misrepresentations and lack of evidence. The case was against the crypto platform DEBT Box.

BofA Grants Support Art Conservation

Bank of America this month named 24 cultural institutions as recipients of its 2024 Art Conservation Project. The recipients represent a diverse range of artistic styles, media and cultural traditions across the world. The program offers funding to support the preservation of paintings, sculptures, archaeological and architectural pieces of critical importance to cultural heritage and art history.