BPInsights: Jul 27, 2024

Regional Bank Mergers Would Increase Competition without Increasing Systemic Risk

Mergers enable banks to reach economies of scale, lower their funding costs and reduce risk by diversifying their funding sources. Large regional banks in particular require geographical diversification to compete in a national market. But recent proposals by the OCC and FDIC would make it much harder for large regional banks to compete by discouraging mergers resulting in banks above $50 billion, and particularly over $100 billion, in assets. Such arbitrary size thresholds have no basis in law or sound policy.

The big picture: The need for a diversified national deposit base is real. A new BPI analysis illustrates a hypothetical combination of five regional banks to demonstrate the sheer scale needed to replicate the largest U.S. banks' national geographic diversification and reach. As former Fed Governor Daniel Tarullo stated, "realizing public benefits from a retooled approach to bank mergers requires more than just an instinct to get tougher." Tarullo said many large regional banks are "caught between, on the one hand, GSIBs with their scale advantages and, on the other, the smaller regionals and community banks…" A combination of tough merger policy and tough regulation may ultimately increase industry concentration by benefiting the very largest banks, he said. A world with more large regional banks "might on balance be the most competitive environment we could hope for," he said, with better prospects for competition both locally and nationally.

Low systemic risk: This post provides several examples of potential combinations of large regional banks that would create beneficial scale and diversification, but maintain low risk to the financial system's stability. The methodology that regulators use to identify global systemically important banks indicates that even mergers among some of the largest regional banks in the U.S. would not create a new GSIB. However, such mergers would increase competition and provide greater funding stability to those banks by accessing nationwide deposit funding.

Productive steps to consider: An effective regulatory approach would enable larger banks to reach the scale they need to compete nationally. This scale would not inherently increase systemic risk.

• To further enhance competition, the banking agencies could also grant more de novo charters, therefore creating new banks in local markets.
• They could also raise concentration thresholds - in practice, often more restrictive in markets where community banks seek to merge to achieve greater scale in a region.
• What wouldn't work: Policies that strongly discourage - or, at worst, effectively prohibit - mergers among regional banks would only stifle competition and innovation, protecting only the status quo. These misguided policies include arbitrary size thresholds or an illegal moratorium on bank mergers.

Five Key Things

1. FDIC's Hill Calls for Joint Reproposal of Basel Rule

It is "necessary" for the federal banking agencies to repropose the Basel Endgame proposal, FDIC Vice Chair Travis Hill said in a speech this week. Hill said he is "skeptical of reproposing only parts of the rule," noting that "everything in the framework is related." He also cautioned against a fragmented approach, saying that any reproposal should be issued jointly by the Fed, FDIC and OCC. If one agency reproposed on its own, that would "be unprecedented, sow confusion, and lead to a number of practical and legal questions," he said.

• Reverse the reversal of tailoring: The banking agencies should "fully reverse the proposed reversal of tailoring of the capital framework for large banks," Hill said. At minimum, the agencies should refrain from undoing the 2019 capital simplification rule and exempt Category IV banks - regionals that usually have simpler, lending-based business models - from the new market risk framework unless they have major trading activities, and the expanded risk-based approach. The volatility of a "two-stack approach" to capital does not make sense for these smaller and simpler banks, he said.
• Liquidity: Hill also touched on potential changes to liquidity rules, warning against new "hardwired" ratios. Hill referred to a requirement under consideration for a minimum ratio of cash plus discount window borrowing capacity to uninsured deposits. He praised the notion of incentivizing banks to prepare for discount window borrowing, but raised concerns that a ratio calibrated to under 100 percent would shine "a magnifying glass on the fact that a bank cannot cover every depositor." Instead, regulators should consider incorporating discount window borrowing capacity into the liquidity coverage ratio, he said. He expressed concern about the mixed message arising from the contradiction between a requirement for pre-positioning discount window collateral and declining to incorporate discount window capacity in the LCR and banks' internal liquidity stress tests.
• A different FDIC funding approach for resolutions: Hill raised questions about the FDIC's unprecedented borrowings from the Fed at a penalty rate after the spring 2023 bank failures, which he said ultimately cost the FDIC about $1 billion - a cost passed directly onto large banks paying the special assessment. He noted that there were challenges accessing Deposit Insurance Fund resources after the failures because of "sensitivities related to the debt ceiling and Treasury's cash position." He suggested that rather than relying on Treasury's ability to redeem the DIF's securities, the FDIC could "leave funds in a deposit account at a Federal Reserve Bank." "The FDIC has an obligation to minimize losses when resolving failed banks," Hill said, "and it is hard to argue we did that here."
• Brokered deposits: Hill appeared to preemptively disagree with a forthcoming FDIC proposal on brokered deposits and called for reconsideration of the statutory framework established 35 years ago. He noted that "it would be a mistake for the FDIC to substantively reopen the brokered deposits rule" and "doubling down on the pre-2020 brokered deposits regime in 2024 is like doubling down on stone castles after the invention of cannons."

2. Treasury Flags State Laws that Could Undermine Banks' Financial Crime Fighting Efforts

The U.S. Treasury Department expressed concern about recently enacted state laws that could impede banks' ability to comply with federal national security requirements. Senior Treasury official Brian Nelson agreed with concerns expressed by a bipartisan group of lawmakers in a recent letter. "State laws interfering with financial institutions' ability to comply with national security requirements heighten the risk that international drug traffickers, transnational organized criminals, terrorists, and corrupt foreign officials will use the U.S. financial system to launder money, evade sanctions, and threaten our national security," Nelson wrote in response late last week to Reps. Josh Gottheimer (D-NJ), Brad Sherman (D-CA) and Blaine Luetkemeyer (R-MO).

• Examples: Treasury provided a recently enacted Florida law as an example of a law that could interfere with the federal anti-money laundering framework. The legislation defines as an "unsafe and unsound practice" a bank's reliance on any factor that is not a "quantitative … standard" to determine which customers to serve or services to offer. It prohibits consideration of affiliations or business sector to make such decisions. "By severely restricting the factors banks may consider when assessing risks, such laws create uncertainty and may inhibit effective anti-money laundering and countering the financing of terrorism (AML/CFT) and sanctions compliance programs, undermining efforts to promote national security," Nelson wrote. In addition, he wrote: "By prohibiting the consideration of any factor that is not 'quantitative,' these state laws could prevent banks from considering these types of qualitative factors and discourage their efforts to appropriately identify and address risks."
• Division of responsibilities: Nelson noted that states play an important rule in banking oversight, but that these types of state laws may "materially undermine compliance with the important AML/CFT and sanctions requirements" administered by Treasury's FinCEN and OFAC.

3. Federal Court Scraps Most of SEC's SolarWinds Breach Disclosure Claims

A federal judge late last week tossed most of the SEC's allegations that SolarWinds violated securities law in its disclosure of a 2020 cyberattack. The attack compromised the networks of several U.S. government agencies that relied on the firm's software, and the SEC claimed that SolarWinds committed securities fraud by minimizing the severity of the attack on its key product in an early disclosure of the attack. The court dealt a significant blow to the SEC by dismissing major portions of its lawsuit.

• Hindsight is 20/20: The SEC's allegations "impermissibly rely on hindsight and speculation," U.S. District Judge Paul Engelmayer wrote in the opinion. "The disclosure was made at a time when SolarWinds was at an early stage of its investigation, and when its understanding of that attack was evolving," the judge said. Engelmayer also dismissed the SEC's internal accounting control claim,, which he said was "ill-pled" because "SolarWinds is clearly correct" that a company's cybersecurity controls do not fall under that provision of the securities laws. The court also dismissed the charges brought against the SolarWinds chief information security officer in his personal capacity. It allowed the agency to move forward with claims that a security statement posted on SolarWinds' website as early as 2017 was fraudulent because it misled the public about SolarWinds' lax access control and password protection practices.
• Implications moving forward: The ruling raises questions about the SEC's approach to cybersecurity disclosure in its recent rule, which BPI has warned would imperil security by forcing public companies to disclose cyber incidents prematurely.

4. Petrou: How to Fix Bank Supervision

Longtime bank regulatory analyst Karen Shaw Petrou offered reforms to make bank supervision "both good and just" in a speech this week. Here are some key takeaways.

• Streamlining bureaucracy: Petrou emphasized the sprawling bureaucracy and size of the examination workforce as a fatal weakness. "Large examination bureaucracies are at grave risk not just of lethargy, but also of being encumbered by so many internal reporting requirements and conflicting incentives that they lack the ability to distinguish material weaknesses from minor failings and then to rapidly resolve or punish persistent material weaknesses and violations," Petrou said. "With so many examiners who, like all employees, are worried at least as much about themselves as about bank safety and soundness, there is no way to ensure that supervision does not spend so much time examining superficial scratches that mortal danger is missed." She went on to say that "Supervisors and the public should not abandon hope of expert examination nor allow this flaw to go unremedied."
• Transparent ratings: The banking agencies should make bank CAMELS ratings public, Petrou urged. Amid the bank failures of 2023, it was clear that "supervisors are slow to act, hesitant to demand, and faint-hearted to enforce." Transparent ratings would be an "effective way to ensure that supervisors know their reputations are at risk if they focus on internal incentives instead of rapid remediation and that bank management cleans up its act before market discipline demands that it does so in no uncertain terms likely past the point of recovery," Petrou said.
• Good policing: Petrou compared effective bank supervision to good policing: law enforcement officers that quickly take criminals off the streets, but treat the accused with dignity and allow them due process. Top-down reviews of supervisory decisions, without structural reforms of the system, "may well only tie the banking agencies into still larger knots of administrative overkill and attention to meaningless detail, leading them to cross off procedural boxes instead of ensuring rapid-fire response to emerging risks. Supervision that is not only good, but also just must balance effective response and mandatory injunctions with the need always to ensure that the rights of supervised banks to a hearing if supervision goes too far must be respected."

5. BPI's Pat Warren Testifies Before House Oversight Subcommittee

Pat Warren, Vice President for Regulatory Technology at BPI's BITS technology policy division, testified on Thursday before the U.S. House Oversight Subcommittee on Cybersecurity, Information Technology, and Government Innovation at a hearing titled "Enhancing Cybersecurity by Eliminating Inconsistent Regulations." The proliferation of cyber regulatory requirements among state, federal and international agencies has led to overlap, duplication and even conflict among requirements, Warren said. "The current approach imposes significant costs and unintended effects that are not always commensurate with a corresponding reduction in risk," he said in the testimony. "We welcome the Committee's focus on this important issue and support congressional action to help solve these significant challenges. A thoughtful, harmonized approach to streamline existing requirements will provide cyber professionals with the time they need to protect their organizations while providing government agencies with access to the information they need to fulfill their oversight responsibilities."

• CrowdStrike: The global outage caused by the CrowdStrike software update illustrates the importance of network security and resilience, Warren noted. In addition to protecting that resilience, cybersecurity regulations must avoid placing unnecessary strain on critical security resources, he said. For example, rules that require companies to disclose incidents within only a few days can divert the attention of front-line personnel who should be focusing on resolving the incident, not completing compliance paperwork.

Key recommendations: Warren outlined three BPI recommendations for regulatory harmonization:

1. Regulatory harmonization efforts should be led by an entity at the national level, such as the ONCD, that can compel action and possesses government-wide visibility into the cyber regulatory requirements issued by federal agencies and independent regulators.
2. That same national-level entity should conduct an assessment of the cyber regulations currently in effect to identify inconsistent, overlapping or contradictory requirements and develop recommendations to achieve increased harmonization.
3. Agencies considering new cybersecurity regulations should be required to consult with the national-level entity leading harmonization efforts to limit duplication and encourage consideration for how the proposed regulation may affect other policy directives.

To read Warren's full testimony, click here.

In Case You Missed It

For the Fed's Discount Window, Destigmatization Starts at Home

Banks' willingness to use the Fed's discount window depends on how they expect examiners to react. A few anecdotes paint a grim picture of their expectations. "When asked recently about borrowing from the Federal Reserve's discount window, a regional bank treasurer who grew up in Bulgaria said the window reminded her of government agencies from her youth - inefficient and unwelcoming," BPI Chief Economist Bill Nelson wrote in a recent Risk op-ed. Betsy Duke, former Fed governor, said borrowing from the discount window was like borrowing from your parents - you'll do it if you have to, but nobody likes doing it. Thankfully, the Fed may be rethinking the discount window's image.

• The stakes are high: The spring 2023 bank turmoil demonstrates a compelling reason to reform discount window stigma, Nelson wrote. Silicon Valley Bank and Signature Bank were both unprepared to borrow from the window, exacerbating the 2023 tumult, and a shortage of discount window collateral across the banking system may have necessitated bailing out banks' uninsured depositors.
• Contradictions: The Fed itself has taken steps that have entrenched stigma about the discount window. So to reduce stigma, the Fed first must address its own behavior, Nelson wrote.
• Moving forward: The Fed could take two steps to decrease stigma. First, it could allow banks to deduct their pre-pledged discount window borrowing capacity from the "maturity mismatch add-on" to their LCR requirements. Second, it could allow banks to point to the discount window as how they plan to monetize their liquid assets in their internal liquidity stress tests.
• Congressional interest: Sen. Mark Warner (D-VA) this week introduced a bill to require testing of discount window borrowing, ensuring banks are more prepared to access the window.
• Bottom line: "Fed efforts to encourage banks to use the window are doomed if bank examiners don't want them to do so, and if banks can't assume that they borrow in liquidity stress situations," Nelson wrote.

Should Banks, Thrifts and Credit Unions be Forced to Make Interest-Free Loans to the U.S. Government?

Some policymakers, including the ECB, have called for banks to lend to central banks without earning interest. In other words, banks would be required to hold deposits at the central bank on which the central bank would pay no interest. This amounts to a forced interest-free loan to the government.

• Misconceptions: Such interest-free lending is unwarranted on the grounds of monetary policy efficiency. It actually would complicate the implementation of monetary policy. It also would single out banks - and in the U.S., thrifts and credit unions, too - while other depositors, like government-sponsored enterprises and foreign central banks, receive interest on their loans to the Fed. And finally, it's not a windfall to banks any more than paying them interest on Treasury bills would be, or paying interest to foreign central banks and international institutions on their loans to the Fed is a windfall for those institutions.
  • Milton Friedman called for central banks to pay interest on reserve balances to improve monetary policy efficiency and to increase fairness.
• Tempting source of funding: Substantial forced interest-free loans from banks would be a dangerous, irresistible source of government funding that would threaten the Fed's independence. It also has other drawbacks - it would make QE ineffective, and weaken the stability of the banking system.
• Timing: These proposals come at a time when central banks, including the Fed, are making significant losses. This is no coincidence. The zero-interest loans would support the central bank's profitability and generate government revenue. As independent, unelected institutions, central banks should not levy a tax on depository institutions.

FSB Flags Nature-Related Risks for Banks in Recent Report

The Financial Stability Board, a global organization of finance ministers, central bankers and financial regulators from the G-20 countries, is weighing the implications of nature-related risks beyond the usual realm of climate change risks, including the risk of biodiversity loss. The FSB published a recent "Stocktake on Nature-Related Risks" summarizing regulatory and supervisory initiatives in this area and presenting key challenges for financial regulators in identifying, assessing and managing such risks. The report outlines case studies from various central bank efforts and describes regulatory and supervisory initiatives, central banks' and supervisors' analytical work on whether and how nature degradation is a relevant financial risk. While the report frames the matter of nature-related risk as a question, it appears to emphasize the perspective of those who believe it does constitute a major financial risk, rather than those who do not. The foray beyond the typical climate-risk focus on greenhouse gas emissions and resulting changes to banks' lending portfolios appears to be in its early stages, but is worth watching as an emerging issue in international financial regulation. The U.S. response to a survey discussed in the report was prepared by the Treasury Department; the Federal Reserve and Securities and Exchange Commission did not respond. Here are some key quotes and takeaways.

• Major challenges: Analysts face major data and modeling challenges to connect underlying nature risks with financial exposures and to translate estimates of financial exposures into measures of financial risk. The report notes that additional data collection by various international organizations "…will contribute to further developing authorities and firms' understanding of nature-related financial risks and of regulatory and supervisory approaches in the coming years."
• Context: The report inquires "about the perceptions of central banks and supervisors regarding whether nature degradation, such as biodiversity loss, is a relevant financial risk." Defining the topic, it says: "Biodiversity plays a fundamental role for economic activities that rely on a range of benefits provided by nature (also known as "ecosystem services"), including providing food and clean water, flood protection, nutrient cycling and pollination. Various financial authorities therefore note that biodiversity loss and other nature-related risks could represent a source of financial risk where the loss of ecosystem services can adversely affect a firm's financial position if its production processes or supply chain disruptions result in reduced turnover or even inability to produce. At the same time, efforts to prevent the loss of such ecosystem services could raise financial risks for firms that are forced to write-down assets that are no longer economically viable."
• Different stages: Global financial authorities are at different stages of evaluating the relevance of biodiversity loss and related risks as a financial risk, and they're using varying approaches. Some have concluded that there is a material financial risk in this area, while others are monitoring international work on the issue. A few authorities have decided not to work on this topic due to gaps in the data and the need to prioritize climate risks.
• More steps needed: Efforts undertaken so far indicate that banks have large exposures to physical risk, but more work needs to be done to translate estimates of financial exposures into measures of risk.
• Disclosure: The practice of disclosing nature-related risk is at an earlier stage than climate disclosure.
• Various risk types: The report flags potential risk areas such as credit risk, market risk, and "Other types of risk: Less attention at this stage is given to other risk types (e.g., liquidity risk, operational and liability risk), although some authorities draw on similar work done for climate risks. For instance, higher reputation or liability risk may stem from the financing of firms that are engaged in deforestation." The report suggests that "the management of nature-related risks is typically integrated as one type of risk driver within the wider regulatory and supervisory framework" - a key point that BPI has made regarding climate risk.
• Mission creep: At the recent Atlanta-Dallas Fed conference, Federal Reserve Board Governor Michelle Bowman discussed potential mission creep around climate policy: "There have been some notable examples of regulatory mission creep, including the climate guidance introduced last year by the banking agencies. I have no doubt that this guidance is well-intended, and that climate change is an important public policy issue. But the question should be whether banks should be required to divert limited risk management resources away from critical, near-term risk management, with a parallel shift in focus by bank examiners. Looking at this guidance through the lens of prioritization, one could reasonably conclude that climate change is not currently a financial risk to the banking system and does not justify a shift in prioritization."

Bank of England's Saporta: 'Let's Get Ready to Repo'

Victoria Saporta, executive director for markets at the Bank of England, set the stage for the Bank's transition to a more normal balance sheet in a recent speech titled "Let's Get Ready to Repo!". The speech envisioned a world where the Bank no longer takes extraordinary monetary policy actions and supplies most of its reserves by lending against collateral. Saporta called for a "repo-led portfolio rather than a gilt-led portfolio" and as a complement to the short-term repo facility. On the need for that complementary element, Saporta said "We are currently reviewing the calibration of the [Indexed Long-Term Repo Facility] to ensure it can play this role effectively." The Bank is seeking to supply enough reserves to meet demand in the banking system, "but no more," she said. The Bank of England is approaching the point where it will no longer have excess reserves, and "it's important that we and you get ready, including through increasing ILTR usage." Saporta emphasized that the central bank expects banks to use the ILTR in normal times, not just "solely for liquidity insurance purposes." The state of play in England contrasts with that of the Fed, which is still awash in reserves in its "ample reserve" framework.

The Crypto Ledger

Here's the latest in crypto.

• Out of the ether: The U.S. SEC this week approved the use of spot Ethereum ETFs, a few months after the approval of Bitcoin ETFs. Ethereum is the second-largest crypto token in the world. The approval marks a key milestone for the crypto industry entering mainstream investing.
• New NY hire: The New York State Department of Financial Services, the state's financial regulator, recently hired Kenneth Coghill to help oversee its virtual currency unit. Coghill most recently served as director and head of innovation and technology risk supervision at the Dubai Financial Services Authority.

Capital One Partners with Hiring Our Heroes to Support Veteran Career Pathways

Capital One highlighted its initiatives supporting U.S. military veterans and other ways to support veteran hiring this week in honor of National Hire a Veteran Day on July 25. The bank offers robust recruiting and professional development programs, entrepreneurship initiatives and financial education programs targeted toward the military and veteran community.