BPInsights: Jul 20, 2024

The Bank Examination Problem, and How to Fix It

Bank examination is in an unseen crisis. The examination regime is failing at its core mission and driving good assets and good people out of the banking industry. It is also degrading banks' ability to support the growth of the U.S. economy. The crisis plays out unseen by the public because the examination regime operates in secret. While regulations like capital and liquidity requirements are visible, the sheer scale and scope of the banking examination force represent the rest of the iceberg beneath the water's surface. Unaccountable, ineffective examination comes at the cost of banks' innovation and efficiency and their ability to drive economic growth.

The state of play: Bank examination is significantly more expansive, less accountable and more focused on immaterial risks than it used to be. Examination has increasingly become a substitute for regulation, but without the benefit of public comment. A BPI survey gives a sense of that increased scale:

• Since 2016, the average percentage of C-suite time focused on compliance tasks or examiner mandates has increased 75 percent.
• The percentage of board time dedicated to the same increased 63 percent.
• Full-time employees in compliance functions increased 62 percent.
• The percentage of IT budgets increased 40 percent.

Trends in compliance with anti-money laundering and sanctions requirements are likely even worse, as those issues involve labor-intensive policies and procedures.

Limited legal authority: The banking industry is uniquely subject to such a regime because banks have access to a federal safety net (deposit insurance and the Fed's discount window) and therefore have moral hazard. But moral hazard does not justify the recent evolution of examiners to "supervise" every part of a bank's business, given the narrow legal authority that Congress granted to bank examiners. Not only do examiners now seek to supervise everything at a bank from the composition of its board of directors to its IT vendors, these "supervisors" are focusing on immaterial risks rather than core financial ones.

• A recent Fed supervision report says that only one third of large U.S. banks are rated as well-managed. This strikes a contrast with large banks' ample capital and liquidity, suggesting the low ratings stem from the "governance and controls" category that involves less material risks.
• The "Management" component of the CAMELS rating system is subjective and unaccountable. A low rating in this category can constrain banks' growth and impose, effectively, a large financial penalty.
• The examination process no longer involves due process or viable appeal options for banks. The convoluted, vast regime depends on the reality that banks must obey examiners even if they disagree with their demands.
• Examiners have incentives to issue many Matters Requiring Attention, and this incentive is unchecked.

Bottom line: The banking agencies have increasingly used unaccountable, secret "supervision" rather than public orders and regulation to enforce change at banks. This fundamental problem must be resolved. Three steps could improve the broken system:

• Eliminate the vague and unaccountable "Management" part of the CAMELS rating system.
• Direct examiners' focus onto material risks.
• Rethink staffing in the examination workforce.

Five Key Things

1. BPI Responds to GAO Report on Regulatory Analysis

The Bank Policy Institute issued the following statement on Thursday's GAO report calling for improvements in financial regulatory analyses:

"The GAO's report highlights the need for the Federal Reserve and other banking agencies to base their rules on proper analysis, and to use public notice and comment to improve that analysis. Not only are transparency and cost-benefit analysis of rules essential to prevent government agencies from needlessly harming the economy, they are also required by law. As we have emphasized in our comments on the Basel Endgame proposal, the inadequate analysis underpinning regulators' proposed capital increases is a failure of both law and policy. The lack of transparency and public comment in the Fed's stress test models has yielded counterintuitive and varying outcomes, and we're encouraged that the GAO is calling attention to it.

With respect to disclosing more information on the stress test's models and methodologies, the report cites Federal Reserve officials saying that they seek to balance transparency with risks to the test's effectiveness. This is a false dichotomy. Transparency is not the enemy of effective stress testing; it is the only way to improve it, as noted in a recent BPI blog post. The report also 'cited concerns about short time frames to adhering to new capital requirements determined by test results.'

The costs of ignoring these problems are clear, and they will be borne by the public: companies seeking to grow, families seeking to buy homes and entrepreneurs seeking to start new businesses. For this reason, the public deserves to weigh in."

Background: A GAO investigation, the findings of which were released today, found that banking regulators need to improve their policies and procedures for analysis supporting their rule changes.

• The report specifically examined major capital and liquidity rules (issued from 2012-2021) and the analyses supporting them.
• These rules included several that effected changes in the stress testing framework: tailoring stress tests to banks' risk profiles, instituting the stress capital buffer (an explicit link between stress test results and larger banks' capital requirements) and reducing the number of stress test scenarios.

Key quote from the GAO: "The analyses regulators conducted for many of the 22 major capital and liquidity rules (issued 2012-2021) that GAO reviewed did not consistently reflect leading practices. Regulators improved analyses in recent years by including more information on a rule's expected impact. However, they did not always identify alternative approaches or quantify benefits and costs. The Federal Reserve also had little or no documentation of its analyses (other than descriptions in Federal Register notices) for three of 21 rules in which it was involved. Documentation for the other 18 rules did not consistently discuss methods and data used and how conclusions were reached."

• The GAO also noted that the FDIC and OCC have revised policies and procedures for regulatory analyses and these "now largely align with leading practices." The Fed has not done such an update since 1994 and should improve its processes with steps such as requiring benefit-cost assessment and documentation of data sources and analyses, the GAO said.
• The regulators have conducted few retrospective reviews of their rules' impacts.

2. What the CFPB Isn't Saying About State Investigations

A recent effort by state attorneys general seeking more information from national banks in state investigations disregards Supreme Court precedent and longstanding law that divide regulatory responsibilities over national banks clearly between state and federal authorities, according to a recent BPI blog post.

What happened: Last December, a group of 21 state AGs wrote to the CFPB and OCC demanding that the agencies require national banks - federally chartered and primarily regulated by the OCC - to cooperate with state AG information requests. Without such cooperation, state AGs would be forced to bring action in court if they suspect legal violations by national banks, the letters said. The CFPB's response to the AGs demonstrates a concerning disregard of the law and Supreme Court precedent that address oversight of national banks. The CFPB embraced the AGs' premise that banks' "lack of cooperation with state inquiries is problematic" and described actions the CFPB will take to facilitate state investigations.

Important context: Two crucial legal concepts are at the forefront of these interactions about national bank oversight: visitorial powers and federal preemption.

• State AGs' ability to enforce laws against national banks begins at the courtroom door. This prevents a conflicting patchwork of oversight from muddling the system. The OCC has exclusive visitorial authority over national banks - including the ability to inspect those banks' books and records on demand. Congress allocated exclusive "visitorial powers" to the OCC to ensure consistent federal administrative oversight by one primary regulator and avoid subjecting banks to an inconsistent patchwork of 50 state compliance regimes. This important division of responsibility was confirmed by the Supreme Court and also effectively codified in the federal Dodd-Frank Act.
• Preemption of state law for national banks is clearly established in court precedent and the Constitution. Federal preemption, which stems from the Supremacy Clause of the U.S. Constitution, means that federal law supersedes state law as "the supreme Law of the Land." This ensures consistency and order for activities of national significance like immigration, aviation and national banks. National bank preemption was recently addressed in a Supreme Court decision, Cantero v. Bank of America, which reiterated previous legal precedents on the subject. According to this decision, a nuanced analysis is required to determine when a state consumer financial law is preempted for a national bank.

A closer look: The CFPB's response to the AGs bobs and weaves around well-established law that allocates regulatory and supervisory authority over national banks between the states and the federal government. Federal agencies like the CFPB should not use their supervisory powers to change this law with threats of administrative action against banks. The agencies must follow Congress's direction and prevent duplicative, conflicting expectations and demands on national banks across the 50 states and the federal government.

3. Reassessing the OFR's Commercial Real Estate Concerns: A Closer Look at Bank Resilience and Risk Factors

A recent Office of Financial Research brief raises concerns about the banking sector's exposure to commercial real estate risks. But a closer look at the data suggests the brief is overstating the potential problems, particularly for smaller banks with significant CRE exposure.

A new note by BPI analyzes the risks of CRE losses for the banks that OFR identifies as most vulnerable - those with less than $1 billion in assets and more than 25 percent of their assets in CRE loans. BPI's assessment demonstrates a much less pessimistic outlook than the OFR brief. These points, among other factors, suggest the OFR brief overstates CRE risk among these banks:

• Capital cushion: These banks have nearly $60 billion in capital to cover $25 billion in potential losses - more than sufficient even in a severe stress scenario. The OFR brief also overlooks the $5 billion the banks have in allowance for credit losses.
• Severe loss assumption: The 8 percent loss rate assumed in the OFR brief is extreme, based on the peak losses of the Global Financial Crisis. The current economic environment is completely different from that period. In addition, large office building loans in major cities face challenges, but these banks' lending portfolios likely focus on local markets, financing smaller commercial properties, mom-and-pop businesses and multifamily housing. These sectors have shown more resilience amid changing work patterns and economic conditions than urban office space.
• Unrealized losses: Banks tend to hold securities to maturity, so the treatment of unrealized losses on securities in the brief is likely overstating the risk in that area. Also, a recession affecting CRE would probably come with lower interest rates, which would reduce or eliminate these unrealized losses.

Bottom line: When considering many factors together - banks' strong capital position, the likely overstatement of CRE losses, the temporary nature of unrealized securities losses and banks' proactive allowances for credit losses - it becomes clear that small banks are less vulnerable than the OFR brief depicts.

4. Hsu: OCC is 'Bulwark' Against State Laws That 'Splinter' National Bank Preemption

Acting Comptroller Michael Hsu said in a speech this week that the OCC serves as a "bulwark" against banks "being asked by states to pick a side in service of performative politics rather than deliberative policy." Hsu described a pattern of state laws - often colloquially referred to as state fair access laws - driven by political polarization, leading to "greater and greater fragmentation of the U.S. financial system." "Just as the advent of national banking was able to help unify a fragmented banking system in the late 1800s, [the OCC] can help ensure that parochial overreach today does not splinter our banking system," Hsu said.

• Preemption: Hsu emphasized the legal doctrine of national bank preemption, grounded in the U.S. Constitution's supremacy clause and in the National Bank Act. "The OCC has and will continue to vigorously defend preemption, as it is central to the dual banking system and cuts to the core of why we exist and who we are," Hsu said. He referred to the recent Supreme Court Cantero decision, which reaffirmed a legal precedent and called for nuanced analysis of when state laws are preempted by federal statute. "We must fortify and vigorously defend core preemption, and we must embrace and develop more nuanced analysis when applying Barnett," Hsu said, referring to the Barnett standard enshrined in court precedent.
• 'Non-negotiable': Preemption in the areas of safety and soundness and compliance with federal laws and regulations is "legally absolute and non-negotiable," Hsu said, and the OCC is prepared to defend it. But questions remain as to how exactly the OCC would do so.
• Preemption precision: Hsu also called for more precision in applying the required analysis from the Barnett court precedent that tests whether state laws are preempted. Specifically, Hsu said the OCC is reviewing its 2020 interpretation of preemption to determine "whether updates are needed in light of the recent Cantero decision." It's not yet clear whether this would involve opening up the existing rules for revisions. Hsu indicated the OCC is pivoting "from expanding preemption to fortifying it."
• Left unsaid: WhileHsu used strong language, he failed to identify any specific actions under consideration, like whether the agency would take on the numerous state laws that violate preemption or encroach on the OCC's exclusive visitorial powers over national banks. So too did Hsu fail to indicate whether the OCC would file amicus briefs in various significant preemption cases pending before the courts. Absent such specific actions, the forceful words have significantly less relevance.
• Other topics: Hsu's speech, which addressed trends shaping the banking system, also reiterated his views on the necessity of large-bank regulatory reforms and the potential dangers in bank-fintech partnerships that involve long-intermediated chains of services. He mentioned the recent collapse of fintech Synapse and flagged the risk of "the public unwittingly expecting banks and bank regulators to cover problems no matter where they occur in the chain."

5. Banks Urge CFPB to Set Appropriate Timeline for Complying with Consumer Financial Data Rule

BPI, the American Bankers Association, the Consumer Bankers Association and The Clearing House Association sent a letter this week to the CFPB calling for the Bureau to set an appropriate timeline for complying with its forthcoming rule governing consumer financial data known as Section 1033. The letter recommends that the first tier of banks required to comply with the rule be given at least two years to comply with the new rule. This would allow enough time for banks to develop new systems and processes and for a standard-setting organization to be recognized by the CFPB.

"Banks spent years developing systems to enable safe data-sharing for 50 million customers and overhauling these systems to comply with this new rule will take time," the Associations stated upon filing the letter. "In the interest of protecting customer data and avoiding disruptions, it's better to get it done right than to get it done quickly. Banks are committed to serving their customers and complying with the law, and we encourage the CFPB to recognize the complexities of the new requirements and establish pragmatic timelines that allow for a smooth implementation without disrupting consumer data access."

The Associations pointed to significant operational hurdles in their letter, including:

• Implementation Challenges: Banks will need to upgrade technologies, standardize data, develop operational policies and procedures, build new functionalities, work with third-party partners and refresh public-facing resources.
• Coordination and Collaboration: Agreements with existing third parties will need to be reviewed and banks will need to coordinate with those entities to amend those agreements to meet the new obligations.
• Standard-Setting Procedures: The CFPB just recently finalized a rule establishing the procedures for a standard-setting body to seek and obtain CFPB recognition, which will be a lengthy process. The process under which a standard-setting organization would develop consensus standards would take even more time.

The associations also recommend extending the compliance deadlines for subsequent groups of entities by 18 months, consistent with the CFPB's proposed phased approach to ensure all stakeholders have sufficient time to meet the new requirements.

In Case You Missed It

Regulators Should Acknowledge Uncertainty in Climate Scenario Analysis

In guidance on climate scenario analysis - an important tool in banks' management of climate-related risk - regulators should acknowledge the uncertainty inherent in these exercises, BPI said in a recent comment letter on a Basel Committee on Banking Supervision discussion paper. Here are some key points in the letter:

• The Basel Committee discussion paper appears to assume that climate risks are material enough to affect banks' capital adequacy and should be incorporated into banks' capital and liquidity assessments. However, the results of climate stress tests and scenario analyses consistently demonstrate that such risk would not threaten banks' capital. It would be inappropriate at this time to incorporate climate risks into banks' capital and liquidity assessments.
• Some aspects of the discussion paper suggest a view that climate-related financial risk should be treated as a standalone risk type. But this is inconsistent with the approach previously used by the Basel Committee framing climate risks as risk drivers that can translate into traditional financial risk types, rather than a standalone risk category.
• The role of climate scenario analysis should be clarified to avoid suggesting banks should use it to assess their climate transition plan or targets. The Basel Committee should avoid framing scenario analysis in a way that constrains banks' business models or strategic planning.
• The Basel Committee should promote flexibility and encourage innovation in climate scenario analysis rather than limiting standardization.

To learn more, read the full BPI letter here.

BPI's Baer and Nelson Speak at Dallas Fed Conference

BPI CEO Greg Baer and Chief Economist Bill Nelson participated this week in a conference titled "Exploring Conventional Bank Funding Regimes in an Unconventional World" hosted by the Federal Reserve Bank of Dallas. Here are some highlights from their remarks.

• Deposits, discount window: Baer discussed deposit insurance in the context of SVB's failure and resulting funding pressures on mid-sized and smaller banks. He emphasized how the discount window and standing repo facility were a preferred alternative to requiring banks to hold more government securities, and discussed in detail how reciprocal deposit programs operate, and their large role in the system.
• Sea change in liquidity: Bill Nelson described a "sea change" in how banks' liquidity is evaluated - previously, liquidity was measured as having reliable, diversified funding; now it is viewed as having a stockpile of liquid assets. He cited five factors driving this change, including a desire to decrease interconnectedness between banks; an unreliable interbank funding market during the Global Financial Crisis; and stigma about borrowing from the central bank.
• Stigma: Nelson, who was formerly a senior Fed official overseeing the discount window, noted that after policy changes in 2003, banks had started to include the discount window in their liquidity plans. But "that progress was more than completely reversed during and after the Global Financial Crisis. Borrowing from the discount window was viewed as having received a bailout; even though the loans were well collateralized, the rate was above market, and the loans were all fully repaid," he said.
• Furious examiners: "Moreover, examiners were not informed of borrowing unless there was evidence of an underlying problem, something that the System's discount window website says is still true, but now bankers tell me their examiners would be furious if they did not tell them if they were going to borrow," Nelson said.
• Breaking the cycle: Nelson drew a link between the current environment of "ample" reserves and liquidity requirements and said "the pernicious spiral between reserve supply and liquidity requirements can be reversed." The Fed could follow other global central banks by reducing the supply of reserves until money market rates rise a bit above the IORB rate and borrowing at the discount window picks up, he said.
• SVB and supervision: At the conference, San Francisco Fed President Mary Daly participated in a Q&A with New York Times reporter Jeanna Smialek, where she made comments on supervision and the Silicon Valley Bank failure. The concept of tailoring could have illuminated evolving risks at SVB earlier on, Daly suggested. "I hope we don't end up with the idea, really, that we should abandon tailoring because tailoring is really important," Daly said. "Tailoring just says, we should have a system of intensity of our supervision or regulation that fits the size and risk and complexity of our firm." Adding too many factors to supervisors' radar detracts from their ability to see the big picture of risk, Daly said. "If you spent all your time checking an ever-growing number of boxes, you don't have enough time to step back and look at graphs … where you're looking at the composite of things, where you can really step back and say, it's not this risk in a silo or that risk in a silo, it's those risks put together," she said.
• 'Back to basics': Daly suggested supervisors should get "back to basics" and focus on key risks. "You don't want to be a mile wide and an inch deep," she said. "You really want to focus on the core things that make for risks that are undue and manage those."

FDIC Sign and Advertising Rule Changes Need More Clarity, Time for Implementation

BPI, the American Bankers Association and the Consumer Bankers Association urged the FDIC to clarify revisions to its sign and advertising rules in a recent letter. "There are multiple aspects of the rule that must be clarified in order for banks to understand the rule's provisions and implement changes to their signage in accordance with the rule," the trades wrote. They also requested an extension of the compliance deadline by one year to Jan. 1, 2026.

• Support for consumer protection: Banks strongly support clear language about deposit insurance that promotes public confidence in the banking system, the letter noted. They also support prevention of false and misleading representations of deposit insurance, especially given the proliferation of "bank-like" products in the consumer financial market that do not come with such protections, the letter noted.
• Insufficient time: In the trades' comment letter on the proposal, they highlighted the need for banks to have enough time to make substantial changes to their digital platforms to comply with the rule - but the final rule does not allow sufficient time, and "there is significant ambiguity around multiple aspects of the rule, which has meaningfully delayed implementation efforts."
• The latest: The FDIC on Wednesday released Frequently Asked Questions on signs and advertising.

The Crypto Ledger

Here's what's new in crypto.

• Paxos probe ended: The SEC has ended its investigation into Paxos Trust in relation to Binance USD, a stablecoin issued and listed by Paxos, according to the digital assets platform this week. Paxos said it received a formal termination notice on Tuesday from the SEC indicating the agency will not recommend an enforcement action against the firm. The action comes after the SEC in February 2023 issued a Wells notice - a precursor to enforcement action - to Paxos warning of a planned lawsuit against the company for violating investor protection laws.
• Legislative draft: Sen. Debbie Stabenow (D-MI) is circulating a discussion draft of a bill to give the CFTC an expanded role overseeing crypto, according to POLITICO. The draft would give the CFTC exclusive jurisdiction over trades involving digital commodities as long as they are not used "for the purchase or sale of a good" or a loan, but would give shared jurisdiction to the CFTC and SEC over trades involving digital commodities and securities or banking products.

HSBC Names Elhedery as New CEO

HSBC this week announced that Georges Elhedery will take the helm as chief executive officer starting Sept. 2, 2024. He will succeed Noel Quinn in the role. Elhedery joined HSBC in 2005 and was appointed to the Board and as Group Chief Financial Officer in January 2023. He previously served as Co-CEO of Global Banking & Markets, where he also led the Markets & Securities Services division.