BPInsights: Jun 29, 2024

The 2024 Stress Test Results and BPI's Recent Testimony

The Bank Policy Institute issued the following statement on the 2024 stress tests:

"This week, it was widely noted that the nation's largest banks had passed the Federal Reserve's stress test. This reflects a continuing misunderstanding of that test, which is unsurprising, given its opacity and complexity.

Since 2020, the results of that test have not been a one-time pass-fail grade; instead, the stress losses are used to calculate an additional binding capital charge on the covered banks. The result of this year's test is an increase in capital requirements for over half of the banks; about one-third of the banks see capital requirement increases of 70 basis points or more; five banks show capital requirement increases exceeding 200 basis points. And the rationale for these increases is very difficult to discern, given the secrecy of the Federal Reserve Board models used to calculate the charge.

A bank 'passing' the test simply means that it is not required to raise capital or shrink assets immediately, and in that sense, banks 'passed' the test.But banks passed because they now all hold large excess capital as an uncertainty buffer given the randomness of each year's test results. Note that for those banks that did not see capital increases, that buffer was held for no reason; that capital could have been allocated to fund a larger number of loans; presumably much of it will now be used for share repurchases."

In addition, this year's stress test results show why transparency is needed, a new BPI analysis explains.

The results reveal significant challenges that need to be remedied. These results demonstrate the necessity of transparency in stress test models and scenarios and the opportunity for public comment, a key theme of testimony at a House hearing this week by BPI's Francisco Covas. Read more here.

Five Key Things

1. Supreme Court Repudiates SEC's Authority to Use In-House Courts

The U.S. Supreme Court on Thursday held that the SEC cannot rely on in-house courts to resolve an enforcement dispute involving anti-fraud provisions of Federal securities law - a significant rejection of administrative enforcement proceedings which dozens of federal agencies employ to enforce laws enacted by Congress. In a 6-3 decision, the Court ruled in favor of a constitutional challenge to the SEC's internal courts, which have garnered legal scrutiny in recent years for their lack of due process as compared to U.S. federal courts (or so-called Article III courts). The case, Jarkesy v. SEC, could have major implications for other regulatory agencies using such courts to pursue civil penalties for statutory violations.

• Key issues: The case centered on whether statutory provisions empowering the SEC to "initiate and adjudicate administrative enforcement proceedings seeking civil penalties" violate the Constitution's Seventh Amendment right to a jury trial. The SEC appealed the 5^th Circuit's opinion holding that the SEC's enforcement of securities laws through an agency adjudication process was unconstitutional on three separate grounds including the Seventh Amendment right that applies to "suits at common law" like faud and actions that seek penalties.
• The Dissent: The justices were divided along ideological lines. The central point of the three-justice dissent authored by Justice Sonia Sotmayor was that the majority's opinion is inconsistent with a Court decision in 1977 (in Atlas Roofing) which upheld a law empowering OSHA to impose civil penalties for statutory violations. Dissenting Justice Sonia Sotomayor said the ruling will unleash "chaos" across the government noting that some agencies, like the CFPB, can pursue civil penalties in both administrative proceedings and in federal court but that other agencies (like the U.S. federal banking agencies) can only pursue civil penalties in agency enforcement proceedings.
• Impact on Federal banking agencies to bring an enforcement action for civil money penalties: A banking agency civil money penalty for breach of fiduciary duty by a bank officer or director would seem to be the most clearly covered by Jarkesy-breach of fiduciary duty is an ancient common law tort like fraud. More generally, cases in front of appellate courts that were stayed pending the outcome of the Jarkesy decision may inform the banking agencies and regulated entities on the extent to which the Jarkesy decision strips the banking agencies of their power to seek civil money penalties against banks and bank personnel (at least until a new Jarkesy- compliant statute has been enacted by Congress).
• Impact on the CFPB: At a minimum, the decision is likely to make it harder for the CFPB to bring enforcement cases in front of an ALJ. The CFPB, however, does have statutory authority to bring actions to federal courts.

2. SCOTUS Overturns Chevron Deference Doctrin

The U.S. Supreme Court on Friday scrapped a longstanding precedent known as Chevron deference that grants broad discretion on interpreting federal law to federal agencies tasked with implementing the statute at issue. The Chevron doctrine directed judges to "defer" to federal agencies' legal interpretations of ambiguous statutory text. The Court in a 6-3 ruling held that the test established in the eponymous Chevron case - Chevron v. Natural Resources Defense Council - improperly prioritized the executive branch's legal interpretations over the judicial branch's. While the cases at issue before the Court centered on legal challenges by the fishing industry, the decision has important implications for financial regulatory agencies that have traditionally enjoyed this discretion. Significantly, the ruling applies only prospectively, and does not jeopardize past cases decided based on Chevron deference.

3. Bowman: Basel Revamp Should Include Thorough Cost-Benefit Consideration

Federal Reserve Governor Michelle Bowman reiterated in a speech this week the need to consider the costs and benefits of the Basel capital proposal before finalizing it. She described the response to the proposal as "overwhelmingly negative from a broad range of commenters." Two key features of the U.S. proposal are its significant expansion of capital requirements, both in the range of banks they apply to and their calibration; and its extension beyond the international Basel agreement, she said.

• Global consistency: Speaking at a London event, Bowman observed that adjusting the U.S. Basel proposal could enhance consistency in capital rules among different jurisdictions to avoid a regulatory "race to the bottom." "The U.S. Basel proposal reflects elements of the agreed-upon standards, but it far exceeds them," Bowman said. "Adjusting the calibration could have the important secondary benefit of enhancing this international consistency."
• Necessary steps: Bowman outlined several necessary areas to address in any future revisions of the proposal, such as: redundancy between the stress capital buffer and the proposal's market and operational risk requirements; outlier increases in assets in the market risk rule; treatment of fee income in the operational risk requirements; and the impact of capital requirements on Treasury market liquidity and intermediation. She also mentioned the need to repropose the rule "to address the broad and material reforms that I believe should be included in any final rule."
• Bottom line: "While these steps would be a reasonable starting place, they are not a replacement for a data-driven analysis and a careful review of the comments submitted," Bowman said. "This would result in a better proposal that includes changes to address not only these concerns, but also many other concerns raised by the public."

4. PwC Report: Basel Proposal Hurts Growth, No Matter the Economic Environment

A recent report by PwC paints a grim picture of the economic effects of the Basel Endgame proposal. The report examines the impact of the proposal on economic growth in different economic conditions, and also assesses its effects on key financial products and asset classes. The Basel proposal would negatively affect GDP regardless of the economic outlook, according to this report. Its main takeaway: The costs would outweigh the benefits.

• Optimal level: "Reviews of academic literature suggest that US banks are currently operating at or near optimal levels of capital," the report states. "Accordingly, negative effects on GDP growth would likely not be offset by the long-term gains achieved by reducing the probability of a financial crisis as the NPR assumes."
• How costs will manifest: Higher capital requirements will lead to less lending and higher borrowing costs, the report says. How precisely these costs will manifest in the financial system is not yet clear, but they would either take the form of reduced returns to bank shareholders, including mutual funds and pensions, or increased costs to consumers.
• Hedging costs: Additional capital requirements for derivatives could require banks passing on excess costs of $10.4 billion per year, the report said. Risk weights on certain mortgage-backed securities could increase by 250%.
• Credit line effect: The proposal's 10% credit conversion factor, a charge applied to unused portions of credit lines, would motivate banks to "reduce credit lines for all customers and reduce credit exposure to segments with traditionally lower credit scores."

The proposal could reduce credit availability for expanding homeownership, and hurt privately listed but creditworthy firms such as mutual funds, the report says. It also discusses how the proposal diverges from the Basel measures in other jurisdictions.

5. Evolve Bank, Flagged for Fintech Partnership Lapses, Suffers Cyber Hack

Evolve Bank & Trust, a small Arkansas lender known for partnering with fintechs like Dave and Marqeta, confirmed this week that it had experienced a cyber hack. Evolve did not name the attacker, but Russian-linked hacking group LockBit 3.0 posted data from Evolve's systems this week, after previously claiming they had hacked the Federal Reserve. It does not appear that any sensitive Fed data has been released by the group, according to Bloomberg. Evolve received a cease-and-desist order from the Federal Reserve and the Arkansas state banking regulator on June 14, flagging shortcomings in the bank's oversight of its fintech partnership and in its anti-money laundering controls.

In Case You Missed It

GM Pulls ILC Application

General Motors' lending arm withdrew its application for an industrial loan company charter with federal deposit insurance, according to the company this week. GM submitted the application in 2020 to the FDIC and to the Utah Department of Financial Institutions. The Utah regulator had approved the application earlier this month, according to GM. The automaker said in a press release that "we look forward to refiling with the FDIC [and Utah state regulator]." Utah is a key hub for ILCs, a quasi-bank charter that commingles banking and commerce, which are generally banned from being combined under the law. GM previously operated an ILC through GMAC, its lending arm that nearly collapsed in the subprime mortgage crisis of 2008.

• Meanwhile: Thrivent Financial for Lutherans received an ILC charter from the FDIC late last week. The FDIC approved both the ILC charter application and the company's bid to merge the Thrivent Financial Credit Union into the bank.
• The big picture: ILCs pose a threat to the banking system because they could allow a massive nonbank commercial firm to benefit from deposit insurance without proper supervision and oversight, or to exploit commercial customer data when offering financial services.

Joint Trades Refute CFPB's Assertions on Wire Transfers and the Law

In a recent letter, BPI, the American Bankers Association, The Clearing House and the New York Bankers Association corrected the record on the CFPB's incorrect interpretation of the law on wire transfers. The letter referred to the CFPB's erroneous legal stance in the New York v. Citibank case, which centers on banks' responsibilities under the law in wire transfer scams. The CFPB contends that the Electronic Fund Transfer Act - the federal law providing certain consumer protections to specific types of electronic payments - applies in the case because the bank linked wire transfer capabilities to its online banking platform and a fraudster initiated an online wire transfer. But this interpretation is wrong, and represents a reversal of the CFPB's own previous view.

• More context: The letter followed a recent joint statement from the trades in response to the CFPB's legally dubious claims on wire transfers. A key question in the case is what law applies when a scammer steals money from a customer's bank account using a wire transfer. In contrast to the CFPB's claims, a consumer's payment order to her bank to initiate a wire transfer is not covered by the Electronic Fund Transfer Act.
• As the trades noted in their amicus brief in this case, applying this law more broadly to wire transfers would impose costs on customers by forcing financial institutions to become insurers against all unauthorized online wire transfers. That would mean higher costs and less convenience for consumers when they make payments.
• What the letter says: The letter notes that the CFPB's assertion that the EFTA applies to online wire transfers is a reversal of its prior stance. It also observes that the CFPB's engagement in "regulation by blog post" is an evasion of proper notice and comment, and therefore a violation of due process.
• Bottom line: Rather than inventing baseless legal principles when it comes to wire transfer fraud, the CFPB should work with the private sector to combat fraud and scams.

FinCEN Issues AML/CFT Program Proposal

On Friday, FinCEN released a notice of proposed rulemaking on AML/CFT programs that is scheduled to be published in the Federal Register on July 3. This proposal is a complement to the proposed inter-agency amendments to the AML/CFT compliance program rule that was approved by the FDIC Board and released on June 20. The comment period for the FinCEN proposal expires in September.
The proposal aims to help strengthen and modernize financial institutions' AML/CFT programs consistent with the Anti-Money Laundering Act to explicitly require such programs to be "effective, risk-based, and reasonably designed," enabling financial institutions to focus their resources consistent with their risk profiles. The amendments proposed in the measure are based on 2020 changes to the Bank Secrecy Act.
The measure would:

• establish a new statement in FinCEN's regulations describing the purpose of the AML/CFT program requirement;
• require institutions to maintain AML/CFT programs with components such as a mandatory risk assessment process; and
• require institutions to review government-wide AML/CFT "national priorities" and incorporate them into their programs

In its press release, FinCEN included a fact sheet for reference.

CISA Misses Mark on Proposed Cyber Incident Reporting Rule

The American Bankers Association, Bank Policy Institute, Institute of International Bankers and the Securities Industry and Financial Markets Association raised serious concerns on Friday in a letter to the Cybersecurity and Infrastructure Security Agency on its plan to implement new cyber incident reporting laws. The proposed rule would require victims of cyber incidents, like a data breach or other attack, to report to CISA within 72 hours of determining that an incident has occurred.

"Congress directed CISA to create a rule that gives regulators timely intelligence without diverting front-line defenders from the immediate task of stopping the attack," the Associations commented upon filing the letter. "CISA has thus far failed to strike that balance, disregarded congressional intent and risks straining the U.S. financial system's cyber defenses. Significant changes must be made for this proposal to be useful to regulators and industry; otherwise, CISA is moving forward with another requirement that prioritizes routine government reporting over the security needs of firms."

The proposal is in response to the Cyber Incident Reporting for Critical Infrastructure Act, which financial institutions supported when it became law in March 2022. CISA engaged in a series of listening sessions following CIRCIA's passage, and the Department of Homeland Security also issued its own set of recommendations identifying 45 different reporting requirements across the federal government, each with disparate standards and thresholds, that warrant greater harmonization. However, the proposal does not adequately address these shortcomings.

FDIC Nominee Hearing Scheduled for July 11

The Senate Banking Committee has scheduled a nomination hearing for FDIC Chair nominee Christy Goldsmith Romero on July 11, according to American Banker. Goldsmith Romero was nominated to replace Chair Martin Gruenberg, who has said he will resign when his successor is confirmed. Gruenberg has faced pressure to resign amid the reports of toxic workplace culture and misconduct at the agency under his leadership.

The Crypto Ledger

Here's the latest in crypto.

• FTX and hedge funds: Hedge funds and distressed-asset investors had purchased the rights to FTX customers' frozen accounts at a steep discount since the firm's collapse, but collecting on the claims may be complicated, according to the Wall Street Journal: "Investors are mired in legal battles with some of the original owners of the claims," the article says. "They allege those former FTX customers abruptly reneged on trades and are suffering from an age-old affliction: seller's remorse."
• Most wanted: The U.S. State Department has increased the reward to $5 million for information on the whereabouts of accused crypto fraudster Ruja Ignatova, according to Bloomberg. Ignatova is accused of masterminding the $4 billion international Ponzi scheme surrounding the OneCoin cryptocurrency.
• New settlement: Crypto investing platform Abra and its founder have settled with 25 state financial regulators over operating a mobile application without the proper licenses.