BPInsights: Nov. 2, 2024

Correcting Misconceptions on Synthetic Risk Transfers

A recent Bloomberg editorial conflates banks' synthetic risk transfers and certain mortgage-backed securities that contributed to the Global Financial Crisis. But this comparison mischaracterizes the nature of SRTs in several ways. A new BPI post breaks down a few inaccuracies and misconceptions in the editorial.

• Stepping back: Synthetic risk transfers allow banks to allocate regulatory capital more efficiently by transferring credit risk to outside investors. "Synthetic" simply refers to the fact that, rather than selling the loan portfolio outright, the bank keeps the portfolio on its balance sheet to maintain client relationships but pays outside investors to bear some of the credit risk on the portfolio. Such transfers reflect, and are motivated by, how standardized risk weights under the regulatory capital rules differ markedly from actual historical loss rates for a particular asset class.
• Context: SRTs are well-established in Europe and Canada but only gained traction in the U.S. recently, after higher equity costs following Silicon Valley Bank's failure increased made these arrangements more attractive from a regulatory capital perspective.
• Key misconceptions:
  • SRTs in the U.S. typically involve banks receiving the entire protection amount in cash up-front. The bank's repayment to the counterparty depends on how the pool of loan performs. This upfront funding eliminates counterparty credit risk: the bank holds the cash and can retain it if the counterparty defaults. Therefore, the editorial's assertion that "Unlike equity, it doesn't absorb any and all losses. It applies only to the designated assets, and it could prove worthless in a crisis if the counterparty can't pay," is factually incorrect.
  • The editorial incorrectly suggests that banks are transferring risk from their least creditworthy loans. Most SRT instruments in the U.S. are short-term and reference a pool of high-quality assets; the reference assets are chosen not because they are high-risk, but rather because regulatory capital charges overstate the risk of low-risk assets.
  • The editorial expresses concern about banks lending to the same nonbank firms that are acquiring credit risk through SRTs, but presents little evidence that this practice is widespread. Even so, when such lending occurs, bank loans to nonbank institutions are secured and overcollateralized, significantly limiting potential bank losses. Additionally, the long-term institutional investors that own such nonbank entities have no incentive for rapid withdrawals of their funding.
• The editorial also appears to advocate for a capital regime where leverage ratios are the binding capital requirements. A binding leverage ratio encourages banks to take on more risk, not less, and ultimately leads to worse economic outcomes.

To learn more about SRTs and how they work, read our recent primer.

Five Key Things

1. FDIC Merger Policy Statement Amplifies Uncertainty

The bank merger review process already entails considerable uncertainty, but the FDIC's newly finalized statement of policy would exacerbate this issue, according to a new BPI blog post. The policy statement's transformation of how bank deals are evaluated, and the FDIC's lack of coordination with other agencies in this critical policy area, would have a chilling effect on new merger transactions. The effect would extend beyond banks' consideration of mergers; it could influence the way they manage risk, make investment decisions and position themselves competitively. Regulatory shifts such as the FDIC policy will have lasting implications for the banking sector's structure and competitive landscape.Legal issues: The post outlines key legal issues that could result in challenges to the policy statement, which effectively creates new regulatory requirements and functions as a final rule.

• The policy statement expands the FDIC's jurisdiction over non-merger transactions.
• It also redefines the meaning of the "convenience and needs" statutory factor in merger review.

These radical revisions of longstanding merger review standards constitute new requirements in the guise of a policy statement, and are ripe for legal pushback.

Bottom line: Striking the right balance between regulating and promoting healthy M&A activity is essential for fostering a robust banking industry in the years ahead.

2. Yellen: Banking Sector is 'Backbone' for U.S. Economic Growth

Treasury Secretary Janet Yellen this week emphasized the "critical" role of the banking sector in U.S. economic growth, observing that U.S. banks have weathered significant stress in recent years. "[I]n recent years, banks navigated the pandemic and made it through the regional banking stress, continuing to serve as a backbone for Americans' financial health and our country's economic growth," Yellen said in remarks at an American Bankers Association conference.

Financial inclusion: On the same day, Yellen unveiled the Treasury Department's National Strategy for Financial Inclusion. The document lays out goals such as promoting access to bank accounts, increasing access to affordable credit and protecting consumers from predatory practices.

Tailoring: In a Q&A at the conference, Yellen acknowledged the benefits of tailoring regulations by banks' size and risk profile and the "substantial burden" of a panoply of rules. "I hope that tailoring can help to reduce the burden for the smaller banks," she said. She also emphasized the necessity of ample capital: "Knowing how important it is to have a healthy banking system in order to have a healthy and resilient economy, I guess my predilection is very much toward robust capital and liquidity, to make sure that we do have a banking system that can support the economy that's safe and sound," Yellen said. Apparently unspecified in this comment was a quantifier of what "robust" capital is.

March 2023 takeaways: Treasury will keep working with the banking sector to address factors associated with the 2023 banking turmoil, such as uninsured and concentrated deposits and unrealized losses on loan and securities portfolios, Yellen said. "This means ensuring that banks are prepared for liquidity stress, including making sure banks have diverse sources of contingency funding, and the capacity to borrow at the discount window and periodically test this capacity," she said.

Risks on the radar: Yellen noted several other risks in Treasury's focus, such as cyber risk, climate-related risk and the role of nonbanks in the financial sector. She also mentioned the critical collaboration between Treasury and financial institutions on sanctions and illicit finance.

3. Fed Intervention in the Treasury Market Likely to Increase

Repo market tightness around the end of the third quarter illustrated the significant problems caused by limited dealer capacity in Treasury markets, reported Reuters' Paritosh Bansal. Some banks withdraw from lending in the repo market at quarter ends to reduce the size of their balance sheets. That contraction in supply, combined with an increase in the need for funding caused by the settlement of Treasury coupon securities, pushed repo rates higher, with one key index rising 33 basis points and hundreds of billions of dollars traded at even higher rates. In response, financial institutions borrowed $2.6 billion from the Fed's standing repo facility, the highest amount recorded (albeit small when compared with the amount of repo market borrowing that occurred at much higher rates). The article notes that such incidents are leading to larger and more frequent interventions by the Federal Reserve to support the Treasury market, a problem likely to get worse given the projected increase in the size of federal debt.

BPI has long pointed out that unreasonably punitive capital charges on Treasury market intermediation have contributed to the decline in dealer capacity relative to the size of the federal debt. For example, the leverage ratio requirement treats all assets as equally risky; that is, overnight loans collateralized by Treasury securities are treated the same as construction and land development loans. In March 2021, the Fed said it would be seeking comments on proposals to fix the distortionary effects of the leverage ratio requirement "soon", but it has still not done so (see press release). Moreover, the Global Systemically Important Bank (GSIB) capital surcharge and the annual stress tests both also require banks to fund themselves with extra capital if they engage in Treasury market intermediation.

4. Regulators Should Take the Reins on Fintech Oversight

BPI and The Clearing House Association commented this week on partnerships between banks and fintechs in a letter to the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve. The letter, submitted in response to a request for information, calls for the banking regulators to exercise their authority to regulate and supervise fintechs directly so that banks are not forced to serve as quasi-regulators. It also emphasizes the need for more public education to help consumers better understand the potential risks of doing business with a nonbank, such as the potential unavailability of federal deposit insurance.

"We believe the combination of direct agency oversight of fintechs and consumer education is imperative to achieve our shared goal of effective fintech risk management," the associations wrote. "The current approach, in which the agencies place all responsibility for ensuring appropriate fintech risk management on the banks, suggests that compliance is primarily a 'bank issue' and need not be a major concern for the fintech."

The letter makes three primary recommendations:

• Regulators should regulate fintechs. Banks recognize their responsibility to conduct due diligence under third-party risk management frameworks. However, banks should not be expected to independently police fintechs. The banking agencies should exercise their regulatory tools and authority - including the Bank Services Company Act - to establish rules, govern compliance and demand greater accountability from fintech companies, especially when the partnership involves higher-risk activities such as when a large percentage of the bank's business is attributable to the fintech's customers.
• Loopholes used by fintechs to engage in regulatory arbitrage should be eliminated. Fintechs have come to rely on partnerships with small institutions as an effective way to avoid regulation. For example, by partnering with an institution under $10 billion in assets, fintechs enjoy a "small bank exemption" under Regulation II of the Dodd-Frank Act; this allows fintechs to bypass limits on what they can charge to process debit and credit card transactions. These loopholes undermine the purpose of the regulations and should be eliminated.
• The banking agencies should educate consumers about what makes a bank a bank. Many fintech companies may look like banks but lack protections and benefits such as federal deposit insurance. Consumers should be able to easily discern whether an institution is a bank or a nonbank and should clearly understand the risks of obtaining financial products through nonbanks. Regulators should require fintechs to offer clear disclosures and support this effort through public education campaigns.

While banks increasingly partner with fintech companies to offer a product or service, the existence of these relationships is not always obvious to the end consumer. The letter focuses on circumstances where fintechs enter into arrangements with banks to facilitate providing end users with access to banking products and services. These arrangements enable fintech companies to directly provide end users with access to a range of banking products, such as checking or savings accounts, payments, lending products or digital wallets.

The request for information was issued in July 2024, and comments were due on Oct. 30. The Agencies will review submissions and use this information to determine whether additional rules are warranted.

To access a copy of the letter, please click here.

5. House Republicans Flag Process Concerns in FDIC's Bank Investor Measure

House Financial Services Committee Chair Patrick McHenry (R-NC) and other committee Republicans expressed concern about procedural issues in the FDIC's scrutiny of large asset managers investing in banks. The FDIC has proposed to require large asset managers to sign new "passivity agreements" to ensure such companies with large stakes in banks remain passive investors. In a letter this week, McHenry, Rep. Andy Barr (R-KY) and Bill Huizenga (R-MI) characterized the FDIC's proposal as a process foul. "The FDIC's actions to move forward on a rule without accommodating full input from all FDIC Directors nor substantively reviewing public comments raise serious legal questions regarding the agency's internal rulemaking processes," the lawmakers wrote.

In Case You Missed It

BPI Recommends Rule Improvements in Regulatory Review Letter

In a recent letter, BPI made several recommendations to improve regulations under the Economic Growth and Regulatory Paperwork Reduction Act of 1996. This law offers the opportunity for the public to provide input on regulations through a review process and identify duplicative or outdated requirements. Here are some key takeaways from BPI's response.

• Misplaced priorities: The letter identifies "overarching regulatory and supervisory trends that demand disproportionate attention to immaterial matters rather than material risks to the safety and soundness of the U.S. banking system." This is a recurring problem with U.S. bank examination.
• Harming low-income consumers: Restrictions on credit card late fees and debit interchange revenue harm lower-income consumers by curtailing availability of credit and low-cost or free checking accounts, the letter says. The regulatory environment surrounding small-dollar loans also curbs a crucial source of credit for vulnerable communities. Excessive capital requirements for products like mortgages and credit cards also harm consumers, the letter says.
• Nonbanks: A regulatory gap for nonbank financial services providers also leaves consumers vulnerable, according to the letter.
• AML: The letter emphasizes the necessity of a risk-based approach to anti-money laundering requirements and Bank Secrecy Act compliance, including reforming requirements around Suspicious Activity Reports.
• Expand the scope: This regulatory review process cannot be complete without including other relevant agencies in its scope, namely the CFPB and Treasury's FinCEN, the letter states.

What You Missed from IMF Week

Here are a few key nuggets from international financial officials in light of last week's annual IMF/World Bank meetings and other recent international regulatory remarks.

• Basel call for unified action: In a speech last week, Erik Thedéen, new chair of the Basel Committee on Banking Supervision, urged jurisdictions to finalize the Basel capital rule as soon as possible. "We need to lock in the financial stability benefits of implementing the outstanding Basel III standards in full and consistently, and as soon as possible," said Thedéen, who is governor of the Swedish central bank. He praised the benefits of a consistent global framework and international cooperation, and warned of the risks posed by deviations from international standards: "Lobbying for deviations at a national level can perhaps provide short-term (private) gains but will ultimately threaten global financial stability," he said. Thedéen also noted the Committee is pursuing further work on liquidity risk and interest rate risk in the banking book following the 2023 banking turmoil. He also mentioned that the recent growth in the use of synthetic risk transfers could be a potential source of risk and needs to be monitored.
• BoE's Woods on competitiveness: Bank of England Deputy Governor for Prudential Regulation Sam Woods gave a speech on Oct. 17 on the intersection of financial regulation and competitiveness. The theme of the speech alluded to the UK government's goals of growth and competitiveness in the economy. A key quote: "[I]t is absolutely not the job of prudential regulators to reduce risks to zero. We may have no appetite for causing a financial crisis. But that doesn't mean we have no appetite for risk. Risk is the lifeblood of a thriving capitalist economy, fuelling growth and innovation. The whole point of having a strong financial system is to enable society to take risks: by providing capital to promising (but uncertain) opportunities, and allowing business and households to pool their risks via insurance and hedging products. Our role as regulators is not to eliminate risk, but to ensure risks are properly managed…." Woods also mentioned the UK's Basel package: "We have been clear that aligning with the Basel standard is important both for stability and competitiveness reasons, given our role hosting one of the largest international financial centres in the world. Our package achieves this alignment in the spirit and the letter without us having to make a material tightening in aggregate capital requirements."
• More work ahead: On Oct. 22, Financial Stability Board Chair Klaas Knot gave a speech highlighting areas of the regulatory framework that still need improvement, in his view. "[T]he final Basel III standards still need to be implemented in many jurisdictions," Knot said. He also called for stronger scrutiny of nonbank financial institutions, flagging potential systemic risks from that sector. He also pointed to the potential for technology to increase the speed of a financial crisis.
• View from the FSB: Knot also set out the FSB's work to maintain financial stability in a letter last week to the G20. He called in the letter for continued momentum in addressing longstanding financial system vulnerabilities related to elevated debt levels and asset valuations, non-bank liquidity and leverage, and asset and funding market interlinkages. The letter also highlighted the FSB's recent report on tokenization, which found that financial stability could be threatened if tokenization scales up significantly without vulnerabilities being addressed. Knot also noted that jurisdictions have made progress in implementing policy and regulatory responses to the risks of crypto-assets but challenges remain in such efforts. Knot also covered topics such as the 2023 bank failures and deposits - the topic of another recent FSB report - and cyber resilience.
• Bailey on nonbanks, emergency central bank lending: Bank of England Governor Andrew Bailey gave a recent speech discussing global financial stability. He emphasized the importance of understanding financial theory and learning lessons from history, and highlighted the need for a macro-prudential approach, new surveillance tools particularly for risks in the non-bank sector and its interaction across the financial system, and emergency central bank facilities that can be temporarily provided in a crisis.
• G7 statement: The G7 finance ministers and central bank governors released a statement last week highlighting various priorities, from the war in Ukraine to artificial intelligence and the green transition. Among other financial sector topics, the statement expressed a commitment to finalize the Basel III framework "in full, consistently and as soon as possible."

BPI Responds to PRA Proposal Affecting Foreign Banks Doing Business in UK

BPI this week commented on the UK Prudential Regulation Authority's consultation paper proposing updates to how it supervises international banks doing business in the UK. The paper proposed changes to the PRA's approach to branch reporting and clarified expectations of banks' booking arrangements. "A major overarching concern for our members is the inherent tension between the PRA's expectations around booking models and those of the ECB," the BPI comment letter says. "We welcome confirmation from the PRA that it works collaboratively with the ECB to reach mutually acceptable solutions where this tension arises." The letter encouraged the PRA to "provide as much information as possible about a firm's options and potential solutions where divergent regulatory expectations have caused constraints in past case studies." Read the letter here.

A (m)Bridge Too Far

The Bank for International Settlements is exiting the mBridge project, a central bank digital currency initiative that some observers viewed as supporting a dollar-alternative payment system for nations like China and Russia. The project enabled central banks from China, Thailand, Saudi Arabia, Hong Kong and the UAE to facilitate cross-border payments using wholesale CBDCs. BIS General Manager Agustin Carstens framed the decision this week as the BIS "graduat[ing] out" of the project rather than exiting because it was a failure or because of political considerations.

• Worth noting: The exit marks a stark about-face from earlier BIS comments on the project, the potential benefits of which were touted in a press release. "The project aims to tackle some of the key inefficiencies in cross-border payments, including high costs, low speed and operational complexities. It also addresses financial inclusion concerns, particularly in jurisdictions where correspondent banking (which connects countries to the global financial system) has been in retreat, causing additional costs and delays."
• Other efforts: Other cross border CBDC initiatives exist, but the only one nearing production was mBridge. The BIS has created a new unified ledger project Project Agorá (Greek for "marketplace") which is structured as a public-private collaboration. Unlike mBridge, Project Agorá includes a pivotal international currency, the dollar.

What's New from Recent FSB Reports

Here are some highlights from recent speeches and reports from the FSB, which were released alongside other key international regulatory publications surrounding last week's annual IMF/World Bank meetings.

• Cross-border payments: On Oct. 21, the FSB published a progress report on the G20 Roadmap for Enhancing Cross-Border Payments. More than half of "priority actions" on cross-border payments have been completed, but work remains to be done to meet regulators' goals and realize the benefits of efforts made so far, a summary of the report states. Priority areas include payment system interoperability, legal, regulatory and supervisory frameworks and cross-border data exchange. Cross-border payments have long been a challenge for global regulators due to several factors, including inconsistent regulatory regimes and the tension between stringent anti-money laundering requirements and free-flowing funds. On the same day, the FSB also published a report on the Legal Entity Identifier system - a way to uniquely identify counterparties to financial transactions across borders. That report observed that the number of active LEIs has increased by 84 percent since 2019, but broader adoption of the identifier in cross-border payments "remains challenging."
• Tokenization: Another report, published on Oct. 22, examines the financial stability implications of tokenization of financial assets. Because of its small scale, tokenization "does not … currently pose a material risk to financial stability," the report says. However, the report identifies potential vulnerabilities of tokenization, such as liquidity and maturity mismatch and asset price and quality. Tokenization could pose risks to financial stability if adopted on a significantly larger scale, "if increased complexity and opacity of tokenisation projects lead to unpredictable outcomes in times of stress" and if identified vulnerabilities are not adequately addressed, according to the report.
• Crypto check-in: The FSB also recently published a status report on the G20 Crypto-asset Policy Implementation Roadmap. The report provided an update on the IMF and FSB's efforts to coordinate on addressing the risks of crypto-assets. The report noted that progress has been made, but expressed concern about data gaps, regulatory arbitrage and particular risks such as stablecoin runs.
• FIRE alarms: The FSB on Oct. 17 released a consultation report on the Format for Incident Reporting Exchange, known as FIRE - a common format that banks can use to flag operational incidents such as cyberattacks for their regulators. This format aims to "promote convergence, address operational challenges arising from reporting to multiple authorities and foster better communication within and across jurisdictions." The report emphasizes that FIRE is designed to enable flexibility among different regulatory authorities.

The Crypto Ledger

Here's the latest in crypto.

• Crypto in Washington: The crypto industry has become a behemoth in political spending this election cycle, according to Axios. Crypto accounts for nearly half the money contributed by corporations to political action committees so far in 2024, according to a new report from Public Citizen cited in the Axios article. Fairshake, the main PAC used by the crypto industry, has raised $169 million - two primary contributors are Coinbase and Ripple, both of which have grappled with regulatory scrutiny. The Axios piece describes a particularly aggressive political strategy from the industry: "No industry has ever before so wholeheartedly embraced raising as much directly from corporations and openly using that political war chest…to discipline lawmakers toward adopting an industry's preferred policies," the Public Citizen report's author, Rick Claypool, writes. "The crypto sector strategy seems to be: give crypto corporations what they want, or your political career gets it."
• BoE lukewarm, but pressing ahead, on digital pound: The Bank of England will move forward with exploring a central bank digital currency despite Governor Andrew Bailey's general skepticism about the prospect of such technology, according to Reuters. "At the Bank of England we're continuing to prepare for a retail CBDC, because to be frank we are not yet seeing enough evidence that innovation will happen in the commercial banking system," Bailey said in recent remarks.
• FTX engineer avoids jail: Former FTX chief engineer Nishad Singh succeeded in avoiding prison time, according to Law360. Singh, who pleaded guilty, testified against FTX founder Sam Bankman-Fried and cooperated with authorities. A federal judge ordered Singh to contribute to the $11.2 billion forfeiture tab and spend three years under supervision.

Wells Fargo Hires Dana Ripley as Head of Communications

Wells Fargo recently announced it has hired Dana Ripley as its new head of communications. Ripley started the role on Oct. 28. Ripley previously ran his own consultancy, 12A Consulting, and prior to that role, served in communications leadership roles at AIG, U.S. Bank and Voya Financial.

Dimon: 'Time to Fight Back' Against Regulatory Onslaught

At an American Bankers Association conference this week, JPMorgan Chase CEO Jamie Dimon said "it's time to fight back" against an onslaught of regulations. He emphasized that the industry is willing to challenge rules in court if necessary. "We don't want to get involved in litigation just to make a point," he added, "but I think if you're in a knife fight, you'd better damn well bring a knife."

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