Tag: Regulation and compliance

What had for months been a broad debate around the wisdom and process of the Basel III capital proposal has narrowed in recent weeks to center on a particular aspect of that proposal: capital retention for banks’ operational risks. 

The so-called Basel III endgame package put forth by the Federal Reserve, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency would also adjust capital requirements banks would face for risk exposures related to credit, trading and derivative contracts — also referred to as credit valuation adjustment risk. But the operational component has drawn the most ire from banks.

“It makes no sense. I mean, that’s the bottom line,” said James Gorman, chairman and CEO of Morgan Stanley, while testifying in front of the Senate Banking Committee on Wednesday. “I’ve been at this a long time, I was on the New York Fed board for years, I’ve seen a lot of rules, some that make sense and it’s a question of how far you turn the dial. This doesn’t make sense.”

Gorman went on to say the proposal would “punish” banks for creating “fee-based businesses,” echoing criticisms put forth by banks, their lobbying groups and even regulatory officials in recent weeks. 

Last week, Fed Gov. Christopher Waller questioned the need for a standalone operational risk charge, arguing that the capital set aside to deal with market and credit risks could be tapped for idiosyncratic events — such as litigation, cyber attacks or fraud. 

“Those are things that don’t typically occur at the same time as a financial meltdown due to a macroeconomic shock. So, they’re not correlated with market risk, trading risk, all the other things that might bring a bank down,” Waller said during an event hosted by the American Enterprise Institute. “I just argue that because it’s not really a threat to this, we don’t need a separate bucket for this. You can use operational risk, paid for out of your standard capital bucket.”

Currently, most banks are not subject to a set standard for maintaining capital to address operational risks. Only banks with at least $700 billion of total assets or $75 billion of cross-border activity face operational capital requirements under the Fed’s advanced approaches protocol, which calls for banks to use internal models to assess their operational risks and corresponding capital needs.

During a speech in October, Fed Vice Chair for Supervision Michael Barr said that operational risk is “inherent in all banking products, activities, processes and systems.” He also argued that the current system for addressing these risks leaves too much room for variance between banks and suffers from a lack of transparency.

“These models can present substantial uncertainty and volatility,” Barr said. “In the agencies’ proposal, the operational risk capital requirements would be standardized rather than modeled and would be a function of a banking organization’s business volume and historical operational losses.”

The switch to a standardized regime was called for by the Basel Committee for Bank Supervision’s latest international standards, which were finalized in 2017. But the accord, known as the Basel III endgame or Basel IV, provided national discretion over certain components of the operational risk regime. This included a provision about whether to factor past operational losses into future capital requirements. The U.S. opted to include this component, while other regulatory jurisdictions — including the European Union and the United Kingdom — have indicated that they will not. 

The proposal establishes operational requirements through a multi-step process. First, bank measure their business volume over the past three years in three categories: Net interest income from financial assets and liabilities, trading activities, and fee-income. Those indicators are then subjected to steadily higher multipliers based on the size of each business, such that the larger the business, the greater the requirements. Those figures are then multiplied by an average of the bank’s average net operating losses over the previous 10 years, a factor known as the internal loss multiplier. 

The net effect of the framework is that all parts of a bank’s business activities are subject to a risk capital weight that results in higher standards for larger banks, and made still higher for banks with track records of incurring losses. 

“Research suggests that banking organizations with higher overall business volume are likely to have exposure to higher operational risk,” Barr said in his October speech. “Further, higher operational losses are associated with higher future operational risk exposure.”

The proposal asserts that this approach will result in greater risk sensitivity in the operational capital framework while eliminating “subjectivity” and “unwarranted variability.” But some say the proposal is emphasizing the wrong risks and could have unintended consequences.

Karen Petrou, managing partner at Federal Financial Analytics, said capital is a “poor palliative” for operational risks, because it is different from other types of risks. While strong capital buffers can ensure banks can continue lending when facing market volatility or economic headwinds, it does little to address the range of idiosyncrasies that come with operational risk, not all of which can be solved with capital. 

“Operational risk is very different from credit and market risk. It’s equivalent to what you do when the lights go out, and the approach that somehow, if you have a pot of money, you will see better is nonsensical,” Petrou said. “What you actually need is a generator, and that costs money.”

Proponents of the new operational requirements say they are necessary both for consistency and to ensure the growth of emerging risks — such as cybercrime and climate change — are adequately accounted for.

“Operational risk is significant and growing, which is why it has long been on the Basel and capital agenda,” said Dennis Kelleher, head of the consumer advocacy group Better Markets. “Measuring operational risk and other types of risk in a standardized way as the rule calls for is critically important for financial stability.  Moreover, less reliance on banks’ internal models also reduces operational risk, which their very models can create.”

But Petrou notes that the rule retains the seven categories of operational risk — internal fraud, external fraud, employee practices and workplace safety, products and business practices, damage to physical assets, systems failures and process management — remain unchanged by the proposal. She also noted that the best way to address future risks is not to look at past outcomes, but for bank supervisors to diligently manage existing risks.

“These rules reflect the fact that regulators don’t trust themselves,” Petrou said. “They’re using capital as a stand-in for effective supervision, which would be far more effective when it comes to operational risk.”

Industry groups have argued that full force of the Basel rules were not designed with U.S. banks in mind, many of which have adopted fee-based business models to a greater degree than their international counterparts. 

But while the operational risk provisions have drawn the most fire from the rule’s opponents, it may also indicate that there is a path forward for the broader proposal if a compromise on operational risk can be struck.

Waller, who cast one of two dissenting votes on Board of Governors against the capital proposal in July, said his concerns could be assuaged if operational elements of the frame were changed for the final rule. Fed Chair Jerome Powell and Barr have both said they would pursue “consensus” among their fellow board members, with Powell saying the final rule will need “broad support.” Barr has made it clear that unanimity will not be the standard, but said he is open to making changes where appropriate.

But revising the operational risk provisions may not be the only obstacle in the way of a Basel capital rule that everyone can live with — there are also legal and logistical challenges posed by the Administrative Procedure Act. For changes to be dramatic enough to satisfy the objections of Waller and banks, the agencies would likely have to re-propose the entire rule, setting back the timeline for completion and implementation significantly. 

Petrou said the issues presented by the proposed treatment of operational risks could not be addressed by small tweaks. Instead, she said, it requires “redesigning” to a degree that the agency would have to put forth a new rule to satisfy the Administrative Procedure Act. 

During a notice-and-comment rulemaking process, agencies can make changes within a final rule so long as they are a “logical outgrowth” of the initial proposal. If a change is more substantial than that, the APA dictates that the agency must issue a new proposal. Determining whether a change meets the “logical outgrowth” standard is somewhat subjective, as there is no set framework for doing so.

“A final rule that only modestly changes the proposal is possible, but only modest changes to the proposal will have a lot of perverse consequences,” Petrou said.

Recent disclosures — both authorized and otherwise — of supervisory activities have reignited a debate over the secrecy standards applied to such information.

Republicans on the Senate Banking Committee are pressing the Federal Reserve for answers on how a litany of confidential supervisory information, or CSI, including actions against seven individual banks, made it into a Bloomberg News report this summer. 

Banks and their allies say the leaks, coupled with the deliberate release of CSI related to Silicon Valley Bank following its failure this past spring, demonstrate how the current confidentiality standards enable examiners to wield unchecked power against banks.

“A regime that really is intended to protect a candid back and forth between banks and their regulators and to protect bank’s sensitive commercial and proprietary information has been, somewhat perversely, converted into a shroud of secrecy that principally serves to insulate the regulators’ actions from public scrutiny,” said Jeremy Newell, a senior fellow at the Bank Policy Institute, a lobbying organization for large banks.

Banks argue that various forms of supervisory guidance — including the issuance of so-called matters requiring attention, or MRAs, and matters requiring immediate attention, or MRIAs — are being used in lieu of more public actions, such as rulemakings or enforcement actions, to steer banking activities. 

Along with the actions taken against seven banks — Citizens Financial Group, Fifth Third Bancorp, M&T Bank Corp., KeyCorp, Huntington Bancshares, Regions Financial Corp. and First Citizens BankShares — the Bloomberg article also noted an “onslaught” of similar activities by Fed examiners against banks with more than $100 billion of assets since the failure of Silicon Valley Bank in March. 

Banks say this uptick is emblematic of supervisors’ ability to scale the intensity of their actions on a whim behind the protective curtain of CSI. 

“It allows the examiners to have far more discretion and take some liberties that they wouldn’t if they knew their exam reports were viewable,” said Anne Balcer, senior executive vice president and chief of government relations and public policy for the Independent Community Bankers of America, a trade group for small and mid-size banks.

Some from the regulatory space argue that claims about CSI being used to obfuscate the movement of supervisory policy ring hollow. Todd Phillips, a law professor at Georgia State University and former Federal Deposit Insurance Corp. lawyer, said banks have avenues for contesting supervisory actions if they feel they are unwarranted.

“If they are really concerned that supervisors are going too far, they can appeal. Every agency has a process for appealing material supervisory determinations and they can use that process,” Phillips said. “The fact that they are talking to the press rather than taking it through the legal process tells me that there’s something to what their supervisors are saying in their MRAs and banks are just upset about it.”

Potential motives for the recent leaks are difficult to ascertain. In their letter to the Fed, Senate Banking Republicans make the case that the leak came from the central bank to demonstrate a more aggressive approach to supervision. Such a theory undermines the banking sector’s belief that examiners benefit from operating in the shadows. 

Others suggest the banks or their representatives could have disseminated the information to open the Fed up to criticism, but such an orchestrated act would open up involved parties to significant penalties, including bans from banking and criminal prosecution. Banks often cited the complications of sharing CSI with their attorneys, consultants or even their corporate holding companies among their gripes against the current regime.

A spokesperson for Sen. Thom Tillis, R-N.C., the seniormost member of the Banking Committee to sign the letter, said the committee had not received a response to their letter as of Monday morning. Sen. Tim Scott, R-S.C., the ranking Republican on the committee and a presidential hopeful, did not join the inquiry, but Ryann Durant, a spokesperson for Scott, said he is tracking the issue independently.

“Ranking Member Scott takes oversight of our agencies seriously, and on this issue, he wanted to receive a briefing directly from the Federal Reserve, which his staff did on September 22nd,” Durant said in a statement to American Banker. “He continues to rigorously monitor how the Fed handles confidential supervisory information, and he appreciates Banking Committee Republicans’ attention to this issue.”

A Fed spokesperson declined to comment on the status of its response to the senators’ inquiry. 

Regardless of who is behind the leak, Aaron Klein, a senior fellow of economic studies at the Brookings Institution, said the episode raises an important question about the reach of the CSI designation.

“Rather than point fingers at each other as to who leaked, step back and ask the question: should this information be kept secret in the first place?” Klein said. “The level of secrecy around bank supervision is too high. Unfortunately, both banks and their regulators have incentives to keep information about supervision a secret. As a result too much is kept from the public allowing both banks and their regulators to escape accountability for their errors.”

Klein is a proponent of making public the aggregate scores banks are given based on capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk, abbreviated as CAMELS. 

He argues that the FDIC’s quarterly report on the aggregate assets at troubled banks would essentially identify the largest banks should their supervisory marks decline. Making all aggregate CAMELS scores public, Klein said, would bring added accountability to both banks and their regulators.

Most banks and their representatives, however, would rather such information be shielded from the general public. A more palatable version of CSI reform would focus on making the designation more navigable, said David Sewell, a partner at the law firm Freshfields and a former lawyer for the Federal Reserve Bank of New York.

Sewell said the three federal prudential bank regulators — the Fed, FDIC and the Office of the Comptroller of the Currency — and the Consumer Financial Protection Bureau and various state-level bank regulators all have their own definitions and standards for what constitutes CSI as well as their own requirements about the conditions under which the materials can be shared, even with other regulatory agencies.

“The definition of what is CSI is so broad that almost anything touching the supervisory process can be considered CSI, including factual documents and conversation with regulators,” Sewell said. “It would be helpful if the regimes were harmonized on the definition of what is CSI, if there was clarity of what that definition is and if there was a common mechanism for sharing it between agencies.”

By law, CSI is owned by the agency, a distinction that allows the material to be shielded from the Freedom of Information Act, which typically makes all correspondence with the government available to the public upon request. To the frustration of banks, this designation trumps other protective legal mechanisms, such as attorney-client privilege and conversations held under non-disclosure agreements. 

Cliff Stanford, a partner with the law firm Alston & Bird and a former Atlanta Fed lawyer, said this status is particularly cumbersome during merger and acquisitions discussions, in which banks must contend with CSI rules while still attempting to be forthcoming with potential counterparties about ongoing issues. 

“In the context of an M&A transaction, we have to be very careful not to disclose CSI to a counterparty, even though there’s a nondisclosure agreement, even though there’s diligence underway to assess whether or not a transaction makes sense,” Stanford said. “That just tests the definitional coherence of what is CSI and what is not.”

Recent years have seen moves to apply more transparency to certain types of CSI, especially at the Fed. In 2018, the central bank began releasing a quarterly report on supervision and regulation, which includes a wide range of industry-level information, including the overall number of outstanding supervisory findings. Even the disclosure of wide swaths of the supervisory record on Silicon Valley Bank in the years leading up to its failure represented a level of openness not previously seen. 

Stanford said these efforts around transparency have encouraged parties in and around the banking sector to think about CSI differently. 

“CSI has gotten increased attention from the banks, their supervisors, policymakers, media and investors. It’s become something that’s been raised in the consciousness, potentially because the added transparency has led to additional curiosity,” he said. “It may also lead to further assessment of whether there is information that can be disclosed if there are additional guardrails put in place.”

Sewell said the Fed’s progress on bringing transparency to its monetary policy actions could be a model for updating its approach to supervisory disclosures. Much like the Federal Open Market Committee releases information from its meetings over time, first as minutes then later as a full transcript, he said supervisory information could similarly be disseminated in a way that mitigates its potential impact.

He noted that a swift change in disclosure policy would likely lead to bad outcomes for banks, but a gradual transition to a more open regime could allow regulators to share more information about supervisory actions at specific banks without inducing panic among depositors or investors.

“More frequent disclosures about MRA findings could destigmatize it over time, if it were done in an orderly way,” Sewell said.

But Phillips said there is a reason why regulators take such a strict approach to confidentiality. He noted that even if banks were to disclose positive information about their supervisory treatment, this could have residual effects on the parts of the sector with less favorable remarks.

“If some banks start advertising that regulators have given them a clean bill of health, institutions that don’t do that may be seen as not having a clean bill of health,” he said. “It creates an incentive that everyone has to disclose information.”

Jeremy Kress, a law professor at the University of Michigan and a former Fed attorney, said there are merits to arguments both for and against changing the rules around CSI, but he does not anticipate changes materializing anytime soon.

While some argue that agencies can work amongst themselves independently or through the Federal Financial Institutions Examination Council to create a more unified framework for defining and handling CSI, Kress and others believe getting the agencies to do so would take an act of Congress. 

“It’s a complex debate that has no easy answers,” Kress said. “Any reforms would have to come from Congress, so you can reach your own conclusion about how likely that is.”

The Federal Reserve Board of Governors will have a full complement of seven governors for the first time in seven months as it heads into its monetary policy meeting next week.

Adriana Kugler, the executive director of the World Bank and professor at Georgetown University, was sworn in as the seventh member of the board on Wednesday morning. She will complete the term vacated by former Gov. Lael Brainard, who left to become the White House’s chief economist in February. That term ends in 2026.

Gov. Lisa Cook, whose term was set to expire at the end of January 2024, was also sworn into a new, 14-year term on the board, running through 2037. Gov. Philip Jefferson, meanwhile, was sworn in as the Fed’s vice chair — a position also previously held by Brainard — for a four-year term. 

President Joe Biden nominated Kugler and Jefferson to their new positions, along with renominating Cook, on May 23. All three were approved by the Senate Banking Committee and confirmed by a vote of the full Senate last week. Kugler and Cook cleared the Senate on a largely party line vote, with Sens. Mike Rounds, R-S.D., Susan Collins, R-Maine, and Lisa Murkowski, R-Alaska, being the only Republicans to vote in their favor. Jefferson enjoyed board bipartisan support, garnering 88 out of 98 votes cast on the floor.

Fed Chair Jerome Powell administered the oath of office to all three governors on Wednesday morning. 

Kugler is on leave from Georgetown, where she is a professor of economics and public policy and serves as vice provost for faculty. 

In 2021, Biden appointed Kugler U.S. executive director of the World Bank’s International Bank for Reconstruction and Development. Before that she was the chief economist in the Labor Department during the Obama administration from 2011 to 2013, and she held research positions at the National Bureau of Economic Research and at Stanford University.

She holds a Bachelor’s degree in economics and political science from McGill University and a doctorate in economics from the University of California, Berkeley.  

Kugler, whose parents immigrated to the U.S. from Colombia, is now the first Fed governor with acknowledged Hispanic heritage, satisfying a call for Latino representation at the highest levels of the central bank that advocates — including Sen. Bob Mendendez, D-N.J. — have been making for years.

Cook, who similarly made history last year as the first Black woman to join the Fed Board of Governors, has added another distinction to her resume: the first Black woman confirmed to a full 14-year term. 

Before joining the Fed, Cook worked as a professor of economics and international relations at Michigan State University. Before that she was a faculty member at Harvard University’s Kennedy School of Government. Her prior government experience includes work done on the Council of Economic Advisors during the Obama administration and a research position at the Treasury Department’s Office of International Affairs.

Since joining the Fed last year, Jefferson has taken on the role of chair of the Fed’s internal Committee on Board Affairs and has served as oversight governor for the office of the Fed’s chief operating officer. 

Before being confirmed to the board last year, Jefferson was vice president for academic affairs and dean of faculty at Davidson College, where he also taught economics. Before that, he was a staff researcher for the Board of Governors and served on the advisory board for the Opportunity and Inclusive Growth Institute at the Federal Reserve Bank of Minneapolis.

Since Brainard’s departure to lead the National Economic Council, the Fed’s Federal Open Market Committee — which consists of governors in Washington and a rotating group of regional reserve bank presidents — has been short one voting member for the past four meetings. 

Next week’s FOMC meeting, which runs from Tuesday morning to Wednesday afternoon, is one of three remaining gatherings for the committee, with the final two convening on Oct. 31 and Dec. 12, respectively.

After multiple months of lower inflation readings and loosening labor market conditions, market participants broadly expect the FOMC to hold the target range for the federal funds rate at 5.25% to 5.5% next week. Opinions vary more widely about what the committee will do at subsequent meetings, with one final hike, a continued hold and potential rate cut all seen as being in play.

WASHINGTON — The Department of Health and Human Services’ recommendation that cannabis be reclassified as a less dangerous drug has renewed interest in Congress in bringing legalized cannabis businesses into the economic fold, but offers cannabis businesses and their banks little relief in itself, experts say.

HHS issued a recommendation to the Drug Enforcement Administration that the DEA reschedule cannabis, also known as marijuana, as a Schedule III substance under the Controlled Substances Act rather than a Schedule I substance — placing it alongside Tylenol and codeine rather than harder drugs like heroin and LSD. 

But Vince Sliwoski, an attorney with Harris Bricken, said rescheduling won’t immediately change how cannabis firms do business or expand the universe of banking partners they can choose from. 

“At Schedule III, marijuana would still be a controlled substance and state-licensed businesses would still be “trafficking” in a controlled substance, contrary to federal law,” he wrote in a recent piece. “The analysis for financial institutions won’t fundamentally change.”

Sliwoski added that the main vehicle for normalizing cannabis’ relationship to the broader economy is for Congress to pass the Secure and Fair Enforcement Act, or SAFE Banking Act, which has been stalled in one chamber of Congress or the other for years.  

“We need the perpetually stalled SAFE Banking Act or some other act of Congress to fix this, so long as cannabis remains on any CSA schedule,” Sliwoski said. “Even if marijuana is moved to Schedule III, cannabis businesses would be stuck with current options — which aren’t as bad as advertised.”

The SAFE Banking Act would establish federal protections for financial institutions that provide financial services to State-sanctioned marijuana businesses, but the legislation has failed to get tacked onto any of the various must-pass bills late last year.

The rescheduling effort initiated by HHS last month would bring cannabis under the regulatory umbrella of the Food and Drug Administration, alongside other drugs that require a prescription. Companies also need FDA approval before they can offer a Schedule III drug.

Shane Pennington, a partner at Porter Wright, said these stipulations mean firms will still be hesitant to bank companies which technically still violate federal law, even if the violations are less severe.

“Until marijuana is clinically proven and approved by the FDA to safely and effectively address medical conditions such as chronic pain or aiding cancer patient recovery, marijuana producers, distributors, and dispensaries will likely continue to have limited access to the financial services industry even if marijuana is rescheduled,” Pennington said.

He also noted that DEA’s process for rescheduling is long and multifaceted, making it a long shot to happen before the 2024 presidential election. The DEA may need to submit its proposed rule to the Office of Management and Budget before publication in the Federal Register, allowing other executive agencies to weigh in on whether and how the rule contradicts other administration policy initiatives. And after publication, the DEA is required to accept and respond to public comments and hold public hearings on the rule, further delaying the process.

“The OMB review, the number of comment letters received, and the number of public hearing requests are elements of the rescheduling review and rulemaking process that cannot be controlled by DEA,” he said. “Each element by itself could extend DEA’s review and rulemaking process [making] it challenging for DEA to publish a final rule prior to the 2024 presidential election, in our view.”

And a Republican victory in the presidential election would likely quash any effort — regulatory or otherwise — to reconsider the federal ban on cannabis, according to Ed Groshans, senior policy and research analyst at Compass Point Research & Trading. 

“If President Biden is re-elected, marijuana will likely be placed on Schedule III in 2025,” Groshans said. “If President Biden loses, the rescheduling process will likely cease to be expedited and the likelihood of the Drug Enforcement Agency using international narcotic treaties to maintain Schedule I status increases significantly.”

While HHS’ recommendation could take some time to make its way through the DEA rulemaking, the announcement has reignited interest in Congress. Bri Padilla, executive director of The Chamber of Cannabis, said in a recent interview with Forbes that while not a panacea, rescheduling is a step in the right direction, and could pave the way for the kinds of broader measures SAFE Banking could provide. 

“Rescheduling might indeed pave the way for the passage of the Safe Banking Act, offering a partial solution to the banking problem that has plagued the industry,” she said. “While federal legalization would provide the most comprehensive remedy, rescheduling could serve as an intermediate step to ease financial hurdles for cannabis businesses, allowing them to operate more transparently within the existing financial system.”

Indeed, shortly after the HHS memo, Senate Banking Committee Chair Sherrod Brown (D.-Ohio) indicated the marijuana banking legislation was a priority as Congress returned from its August recess.

Jaret Seiberg, managing director at TD Cowen, said he expects the committee to vote on SAFE as soon as September 20, opening up the possibility of a full Senate floor vote late in the year. He believes the SAFE Act has a filibuster-proof 60 vote consensus, a potential pathway to passage through the chamber.

“It is likely that Senate Majority Leader Chuck Schumer (D.-N.Y.) will seek to pass SAFE through the full Senate in Q4 2023,” he wrote in an email. “We believe it is likely to get a vote as we expect there will be at least 60 senators backing it — enough to overcome a filibuster.”

While Democratic-led Senate could very well pass the Act, the Republican-held House is another story according to Seiberg. He said the majority GOP chamber will oppose certain social justice clauses in the Act, since its leadership has been lukewarm at best towards the measure.

“Passage in Senate Banking would be a positive, as would passage by the full Senate,” he said. “However, the most likely path [to full enactment] will be as a provision included in a broader package that Congress tries to enact next year … often referred to as an omnibus. It usually becomes law during the lame duck session after the election [and is] when the most horse-trading occurs among leadership to get bills enacted before the next Congress takes over.”

And that’s not to say Senate passage is a fait accompli either. Some Democrats have previously expressed concern with a clause in the bill which would repeal Operation Choke Point — an Obama era policy which critics say the executive branch wielded to discourage banks from doing business with certain kinds of businesses like pawn shops and gun manufacturers. Proponents of the policy believe its repeal would make it harder for regulators to pressure banks to cut ties with certain customers for reputational risk reasons.

SAFE banking lobbyist Don Murphy agreed talk of rescheduling could be pivotal for the legislation, but he hopes Congress can act before the DEA does. Final rescheduling of cannabis in the absence of SAFE, he said, could actually undercut congressional enthusiasm toward its broader reforms.

“The recent recommendation by the Department of Health and Human Services could have significant implications for the bipartisan SAFE Banking Act,” he wrote in a message. “If the DEA accepts the HHS recommendation and moves cannabis to Schedule III before the SAFE Banking Act is passed by Congress, it could reduce the urgency and pressure for both Democrats and Republicans to support this legislation.”