BPInsights: Oct. 12, 2024

If It Looks Like a Bank and Talks Like a Bank, It Should Be Regulated Like a Bank

BPI commented this week on an FDIC proposal to amend its rules governing industrial loan companies and their parent companies. Industrial loan companies are state-chartered institutions largely indistinguishable from banks, except for one key difference: their parent companies are commercial entities, such as car companies or internet retailers, not subject to federal regulation or supervision. As a result, unlike regulated bank holding companies, ILC parents can engage in commercial activities. The FDIC's proposal tightens these rules and applies additional scrutiny to ILCs and their parent companies.

What we're saying:

"We support the proposal but urge the FDIC to go even further to ensure regulations are applied consistently and equally," stated Paige Pidano Paridon, BPI Co-Head of Regulatory Affairs. "ILCs shouldn't be a shortcut to avoid compliance costs at the expense of financial stability or consumer safety. A company doing business as a bank should be regulated as a bank."

What we want:

The FDIC's current rule requires ILC applicants to agree to certain preconditions before their charter is approved, such as providing the FDIC with a list of all of the ILC parent's subsidiaries, submitting an annual report to the FDIC about the ILC parent's operations and undergoing an independent audit annually.

• The proposal expands this list of prerequisites the FDIC will consider and addresses factors such as whether the ILC can remain in business if the parent company fails. Despite these improvements, ILC parent companies continue to operate under less stringent requirements than their banking counterparts.

BPI recommends the following:

1. Phase out grandfather clauses. Rules exist for a reason. Just as classic cars aren't allowed to run red lights, ILCs should have to follow the current rules and regulations, regardless of when and how they were created.
2. Petition Congress to close the ILC loophole. U.S. policy has long recognized the risk of mixing banking and commerce. Congress should acknowledge these risks and close the existing loophole in the Bank Holding Company Act that exempts ILCs from the same supervision as banking organizations.
3. Reimpose the moratorium on approving ILC charters. Until Congress acts to close the ILC loophole, the FDIC should reimpose its moratorium on new ILC charters.
4. Turn handshake agreements into law. Rather than applying the rules on an ad hoc basis, the FDIC should promulgate regulations setting forth requirements for ILCs. Additionally, any rule applied to the ILC should also apply to the parent company.

What's the background?

Industrial loan companies originated in the early 1900s to offer financing to industrial workers who couldn't obtain credit. These institutions evolved through the 20th century but were mostly small, local lenders. In 1987, Congress passed the Competitive Equality Banking Act, which included a loophole carving out ILCs from the definition of a "bank" under the Bank Holding Company Act. There were only 11 ILCs as of 1987 with an average asset size of less than $45 million. By 2005, there were 58 ILCs with combined assets of $213 billion.

This dramatic increase, along with widespread opposition to Walmart applying for an ILC in 2005, resulted in an FDIC moratorium on new ILC applications in July 2006. The moratorium was reimposed under the Dodd-Frank Act but was lifted in 2020 with the approval of ILC applications for fintech companies Square and Nelnet. The FDIC instituted its current set of rules for ILCs in 2020 and this latest proposal would strengthen these requirements.

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

Five Key Things

1. Should the Federal Government Oversee Fintech Payment Apps & Stablecoins? Here's What a Treasury Official Says

As fraud, scams and flimsy customer protections at nonbank payment apps and stablecoin issuers draw policymaker concerns, questions are emerging on how to oversee this growing part of the financial ecosystem. In a speech this week, Treasury Under Secretary for Domestic Finance Nellie Liang highlighted the growing risks posed by nonbank payment apps and stablecoin issuers and the need for greater federal regulation and oversight of their activities. "Our current state-based regulatory framework has not kept pace with the growth in new kinds of money and payments, raising risks for the integrity of the payment systems and trust in money," Liang said in remarks at a Chicago Fed conference.

• The problem: Liang identified the rapid growth of both stablecoins and nonbank payment apps that move customer funds and hold customer balances "outside of the traditional system of regulated banks and central banks," noting that these new market players present risks to consumers and the financial system if not properly managed. Liang also emphasized these nonbank financial institutions are currently subject only to a patchwork of state laws and rules that don't address important risks, including the financial strength of the firm and how it invests and safeguards customer funds.
• The proposal: To address current regulatory gaps, Liang outlines a new federal framework of regulation and supervision for these nonbank payment service providers - which she terms "e-money issuers" - based on four key elements. First, she suggests that e-money issuers should back all e-money claims with high-quality and liquid assets and should be required to have minimum financial resources to reduce the risk of their insolvency. Second, she highlights the need for risk management standards for such firms, with particular focus on operational and third-party risks. Third, she calls for "a federal supervisor with the authority and resources necessary to examine e-money issuers and be able to act if standards are not being met." And fourth, she suggests that the activities of e-money issuers be limited to payments, and that limiting their affiliation with commercial firms might also be warranted.
• Potential access to central bank payment rails: Liang also notes that the "introduction of a federal prudential regulatory framework for payments also raises the possibility that e-money issuers could get direct access to some public payment rails" under the Federal Reserve's existing account access guidelines, which suggest that depository institutions that are subject to prudential regulation are more likely to receive an account. Liang's speech does not, however, acknowledge or discuss the serious risks to the financial system and consumers that would be posed by granting central bank accounts and services to financial institutions that are subject to anything less than the complete and comprehensive protections of the U.S. bank regulatory framework.
• A federal framework already fit for purpose: Similarly, Liang's remarks don't discuss the simplest and most obvious answer for properly regulating e-money issuers that, like banks, hold and move customer funds and expose their customers to risk of loss if and when they fail: simply applying the existing federal bank regulatory framework to stablecoin issuers and payment apps that hold and move customer funds.

2. BPI Objects to 'Check-the-Box Status Quo' in Overhaul of Illicit Finance Rules

BPI reiterated serious objections to regulators' approach to updating illicit finance rules in a letter sent this week to the prudential regulators. The Anti-Money Laundering Act of 2020 requires regulators to work with the Financial Crimes Enforcement Network and banks to strengthen anti-money laundering and combating the financing of terrorism programs. While the goal is to improve the effectiveness of AML/CFT programs by leveraging technology and transitioning to a risk-based approach, the proposal instead continues to primarily focus on documentation and check-the-box exercises.

"The proposed rule will neither implement the intent of Congress in enacting the AML Act nor facilitate a risk-based approach to identifying and disrupting financial crime," the letter states. "At present, the AML/CFT regime purports to be risk-based but tolerates little to no error with respect to even the most mundane, clerical, and low-risk tasks. In practice, examiners are exactingly focused on technical compliance … rather than on effectiveness. This approach is utterly divorced from a focus on management of true risk."

To learn more, including BPI's key recommendations, please click here.

3. From World War I to Today: Fed's Jefferson Outlines Past, Present and Future of the Discount Window

In two speeches this week, Federal Reserve Vice Chair Philip Jefferson traced the history of the Fed's discount window, where its stigma began and how to address it going forward. In 1913, the discount window was the Fed's main monetary policy tool; in the 1920s, it helped stabilize banks under pressure from World War I aftermath, but sparked concerns that banks overusing it would become weaker and more prone to failure. Stigma began to take root around borrowing from the window, and policymakers have struggled to rein in that stigma ever since.

• Major shift: In the late 1920s, the Fed switched to open market operations as the primary monetary policy tool, allowing the central bank to determine the aggregate amount of liquidity in the system and rely on private markets to distribute it efficiently, Jefferson said in the first speech. This would position the discount window as a safety valve for liquidity shocks.
• Standing ready: "The intention of this set-up was for banks to use the discount window to borrow from the Fed only occasionally," Jefferson said. "Ordinarily and predominantly, financial institutions were supposed to rely on private markets for their funding. This set-up was designed to limit moral hazard-the possibility that institutions take unnecessary risks when there is no market discipline. This is the key balancing act. The Fed needs to be a reliable backstop to prevent financial crises, but it also needs to minimize moral hazard that comes from always standing ready to provide support." He described how stigma reached a notable high point in the 1980s and early 1990s. That increased stigma rendered the discount window less effective as a crisis-fighting and monetary policy tool, which led to a series of Fed actions in the 2000s to change how the discount window operates.
• Further changes: Jefferson's second speech covered developments for the discount window in the 1990s-2000s and referred to a reassessment of the window implemented in 2003. "The key challenge in the reassessment of the discount window was to establish a lending program that would not only operate effectively and support monetary policy implementation, but also mitigate moral hazard and provide sufficient controls to minimize risk to Reserve Banks and, ultimately, to American taxpayers," Jefferson said. "After the reassessment, the Fed implemented several changes aimed to achieve the right balance." Those changes included launching a two-tiered program of discount window lending - "primary credit" at an above-market rate, and secondary credit for institutions not eligible for primary credit. He described some challenges with the window in recent years and said reluctance to use the window is difficult to measure.
• Where things stand: The history of the discount window is important to understand as the Fed considers how to ensure its effectiveness as a source of liquidity to the banking system in an evolving economy, Jefferson said. To that end, the Fed is gathering information from the public in a recent request for information, seeking feedback on "a range of operational practices for the discount window and intraday credit, including the collection of legal documents; the process for pledging and withdrawing collateral; the process for requesting, receiving and repaying discount window advances; the extension of intraday credit; and Reserve Bank communications practices."

4. FDIC Extends Comment Period for Brokered Deposits Proposal

The FDIC this week announced an extension of the comment period for its brokered deposits proposal from Oct. 22, 2024, to Nov. 21, 2024. The action responds to feedback from a wide range of commenters, including BPI, that the previous comment period did not provide enough time for robust input, although the extension is shorter than the group had requested. The FDIC did not address industry requests for withdrawal of the proposal or the release of relevant data to support the proposed changes.

• Context: The proposal would reverse important changes the FDIC implemented in 2020 and broaden the types of deposits considered "brokered," which could increase costs and lead to changes in how customers access financial services. "We are concerned that the brokered deposits proposal would significantly alter the FDIC's brokered deposit framework, and reverse statutory interpretations without sufficient or transparent data or robust policy rationale," BPI and a coalition of 10 other financial trades said in a letter.
• Another extension: The FDIC on Tuesday also said it is extending the comment period for its request for information on deposits until Dec. 6.

5. EU Leaders: Overzealous Banking Regulation Stifles Global Competitiveness

A group of major European finance ministries decried the overregulation of the banking industry as a risk to the European Union. The treasury heads of France, Germany and Italy urged the European Commission to support a competitive banking system by pausing new regulatory initiatives in the near-term. In the longer term, EU policymakers should adjust banking regulations to ensure the industry can compete on a level playing field and finance the economy. They cited the necessity of a robust banking sector to make Europe competitive in the global market, the goal outlined in a recent report by former ECB chief Mario Draghi.

Why it matters: The letter sends a strong political signal by having the three largest member states, who do not always agree on approaches to banking regulation, joining forces and aligning on a set of policy priorities for banking with a pro-business focus/competitiveness focus.

Worth noting: The letter also calls for a pause on large scale new initiatives with the aim of strengthening the resilience of banks and a shift of focus on implementation. The letter flags the Fundamental Review of the Trading Book - the market risk component of the Basel rule - as particularly important for Europe aligning with other jurisdictions.

Key quote: "The more competitive our banking systems, including national champions, the better equipped they will be to finance key European goals," the authors write in the letter, dated Sept. 24.

Context: Threats to European competitiveness worldwide have recently been a frequent topic of commentary among policymakers, including in the recent Draghi report. Themes of an overregulated European economy, particularly in the banking sector, have emerged in the context of post-Brexit realignment, the diverging circumstances of the EU, UK and U.S. on the Basel III Endgame proposal and the M&A environment. There has been an EU capital markets union in the works, a relevant piece of context amid the United States' dominance in capital markets. One message resonating among Draghi, French President Emmanuel Macron and other policymakers: Europe needs regulatory reform, robust markets and economies of scale to compete in the global arena.

The main asks: The banking regulation letter urges the European Commission to take the following actions:

1. Ensure a level playing field with other jurisdictions on banking regulations, namely the Fundamental Review of the Trading Book and the net stable funding ratio. The letter goes so far as to say that as well as the current extension postponing the entry into force of the FRTB they should also prepare a proposal should the US diverge significantly from the EU on the Basel proposal.
2. Ensure proportionality and risk-sensitivity (and avoid overreaching) by the European Banking Authority in adopting level 2 and 3 and guidelines.
3. Identifying areas that can be simplified to cut red tape and add flexibility to banking rulemaking and supervision.
4. Revitalize the securitization market.
5. Address climate and transition risks in a coherent and more realistic manner.
6. The importance of safeguarding competitiveness in a potential macroprudential review.

Taking stock: The letter urges the European Commission to take stock of the competitiveness of Europe's banking sector in a broad new report.

Fragmentation: Fragmented approaches among different European countries have stifled growth and competition on the Continent, according to some policymakers. Fragmentation in banking regulation impedes the efficiency of the EU as a whole, which can harm competition. There has also been a recent focus on divergence between the EU, US and UK, particularly in capital requirements.

In Case You Missed It

The Crypto Ledger

Here's what's new in crypto.

• Gensler throws cold water: It's unlikely bitcoin or another cryptocurrency will gain traction as a true currency, SEC Chair Gary Gensler said this week. "These debates literally go back to Plato and Aristotle," Gensler said at a New York University Law School event this week. Citizens tend to converge on one single currency for each nation, he noted. "You want one currency unit because it's a store of value, a medium of exchange, a unit of account. It all has tremendous economics of networks … So it's unlikely this stuff is going to be a currency. It's going to have to show its value through disclosure, through use. … The same way you pick amongst the thousands of securities that are listed on the stock exchange."
• Crypto platform strikes first: The crypto platform Crypto.com filed a lawsuit against the SEC after receiving a so-called Wells Notice indicating the regulator's intention to sue the exchange for operating as an unregistered broker-dealer and securities clearing agency. The lawsuit seeks to prevent the agency from "unlawfully expanding its jurisdiction to cover secondary-market sales of certain network tokens sold on Crypto.com's platform."

Dimon: U.S. Has Become 'Anti-M&A Country'

JPMorgan Chase CEO Jamie Dimon described the grim, delay-prone state of M&A in the U.S., highlighting bank M&A as a particular challenge. "We've just become an anti-M&A country, and that's a bad idea," he said. Midsize banks should be allowed to merge, and certain business lines require economies of scale, he said. Regulatory delays are a key factor in M&A backlogs, he said in an interview this week with Bloomberg TV. Dimon also weighed in on the future of artificial intelligence, the overall economy and unintended policy consequences for lower-income earners.