Basel Reproposal, Liquidity: What to Know from the Powell Hearings

BPInsights

Federal Reserve Chair Jerome Powell testified this week before the House and Senate in a regular oversight hearing. Here are some noteworthy exchanges.

Redo coming
Powell expressed support for a reproposal of the Basel Endgame capital proposal during the hearings. “It is my view, it is the strongly held view of members of the Board, that we do need to put a revised proposal out for comment for some period,” Powell said at the Senate hearing. “And the reason is … when there are broad and material changes, that has been our practice, we don’t see a reason to deviate from that practice. It seems to be consistent with past practice and with the Administrative Procedure Act. So that’s very much what we think and we’re working through that question with the FDIC and the OCC.  We haven’t reached agreement on that, but I’m very hopeful that we will.” He said reproposal was “essential” given the significance of the changes under consideration.

At the House hearing the following day, Powell clarified that it would be a partial reproposal. In response to Rep. Andrew Garbarino (R-NY), he said: “There will be additional changes that will be made that won’t be reproposed. That’s what we’re working on rather than a full, wide proposal.”

• BPI’s view: “We are heartened that the proposal has been rethought and that the public will have a chance to comment on the rethinking; however, the details here are crucial, so obviously we will need to see the scope and details,” BPI CEO Greg Baer said in a statement on Tuesday. “And of course there remains the question of how the Basel proposal fits with the Federal Reserve’s stress test, the GSIB surcharge and other regulatory requirements.” We also strongly believe that a full reproposal is necessary, rather than the partial one that the agencies appear to be pursuing.
• Timing: When questioned about the timing of a reproposal, Powell predicted that a “partial” reproposal likely “couldn’t happen … until part of the way through the fall” and the agencies likely couldn’t adopt a final rule until “well into next year.” That estimate accounts for a 60-day comment period, time to consider comments and to draft a final version. He emphasized that the Fed wants to “get it right” and move in a way that establishes “a sustainable set of rules.” Powell repeatedly noted that the Fed still needs to reach agreement with the FDIC and OCC on their next steps moving forward.
• Legal approach: When asked if the material changes Powell expects for the proposal would constitute a “logical outgrowth” of the original proposal – in other words, if it would meet the legal test to require reproposal – Powell said he did not want to make that legal judgment. 
• Consistency: On the topic of how the U.S. Basel proposal differs from other jurisdictions’ approach, Powell said: “I think our endgame proposal … at the end, should be consistent with the requirements of Basel and consistent with what the other large jurisdictions are doing.”
• Real economic costs: Sen. Katie Britt (R-AL), Rep. Zach Nunn (R-IA) and other lawmakers emphasized the costly implications of the current Basel proposal for farmers’ hedging costs, small businesses and credit availability. Rep. Young Kim (R-CA) also noted the proposal’s impact on regional and foreign banks doing business in the U.S., particularly through the operational risk charge.
• Substantive changes: Reuters reported this week that the Fed is considering updating the GSIB surcharge, a component of capital requirements for the largest global banks, to account for economic growth.

Other regulatory topics:

• Liquidity: Powell said the Fed is working toward issuing a liquidity proposal “sometime later this year,” though he cautioned that he didn’t “want to put a specific timeframe on it.” Finishing Basel is the first priority before proceeding to a liquidity measure, he said. In response to Rep. Young Kim (R-CA), who asked if the Fed had collected data from the industry about potential changes’ impact on the liquidity framework, Powell said “this is the beginning of the process, not the end” and the liquidity measure is in a “pretty early stage.” A lesson learned from SVB is the unexpectedly rapid pace of bank runs – “we need to we need to bake that new learning into liquidity requirements in some way or other,” Powell said. In addition, several lawmakers noted the challenges with the Fed’s discount window, such as a persistent stigma surrounding borrowing from it. Powell acknowledged the need to address discount window stigma and operational infrastructure. Another takeaway from the SVB failure is that “the discount window worked, but we can certainly modernize it and make it more effective,” Powell said.
• Stress tests: Rep. Young Kim asked Powell if the Fed is discussing increasing the transparency in the stress tests. He responded that “We know that the stress test has to evolve over time if it is to remain relevant … I think transparency is one of those subjects where we’re … prepared to listen and think about ideas.”
• Nonbank oversight: Rep. Scott Fitzgerald (R-WI) asked if the Fed is planning to indirectly regulate nonbank financial firms through the stress tests. Fitzgerald flagged detailed data requests in the Fed’s latest FR Y-14 proposal, which is used to gather information for the stress tests. Powell said “that’s not the idea,” and the Fed is trying to understand the extent of risks inside the banking system and the business ties between banks and large nonbanks.
• Debit interchange: Rep. Nikema Williams (D-GA) expressed concern about the effect of the Fed’s debit interchange proposal on low-income communities’ access to low-cost financial services. “We’re very focused on things like Bank On as you pointed out and on access to the financial system for marginalized communities and we wouldn’t want to do anything to weigh on that,” Powell said.
• Long-term debt: During the House hearing, Rep. Fitzgerald called for the long-term debt proposal to be tailored, as the law requires, so that “regional banks aren’t treated more harshly than the largest banks.” He expressed particular concern about the requirement for regional banks to hold long-term debt at both the holding company and insured depository institution.

Five Key Things

1. The Public Deserves to Know More About the FDIC’s Actions Following 2023 Bank Failures

The FDIC has provided minimal transparency about its financial management choices and decision to levy a special assessment on large banks to recoup the costs of invoking the systemic risk exception following the spring 2023 bank failures. The public deserves answers about the FDIC’s choices, especially those that resulted in needlessly higher costs, BPI said in a letter sent this week. The FDIC’s Office of Inspector General should provide these answers by investigating the agency’s decision-making surrounding the bank failures and the related assessment to recover costs.

“By all accounts, the resolutions of SVB and Signature Bank went very badly, but at this point we have only partial accounts. If future resolutions are to be handled competently, the public needs to know what happened in these cases, and a better process needs to be found. The banking industry has a vested interest in the outcome, as it pays the bills for the FDIC’s shortcomings, but the public too should know what happened.” – Greg Baer, BPI President and CEO

Context: The FDIC invoked the “systemic risk exception” in the wake of the spring 2023 failures of SVB and Signature Bank, enabling regulators to intervene to prevent systemwide contagion. As a result, billions of dollars in costs to the Deposit Insurance Fund must be recouped with a special assessment on banks.

• Despite the stability of the largest U.S. banks during last year’s turmoil, these banks have borne the brunt of the FDIC assessment, which the agency finalized prematurely without sufficient explanation of their policy choices. The estimated amount of the assessment continues to change following a 25 percent upwards adjustment in the quarter after adoption.
• The special assessment rule sets an arbitrary threshold of $5 billion for exempting banks from paying any assessment. This has no sound rationale.
• The FDIC’s explanation of its policy choices in the final rule imposing a special assessment on large banks does not satisfy the agency’s fundamental procedural obligations under the Administrative Procedure Act.
• The OIG should investigate the agency’s unexplained decisions in its approach to both the special assessment and the failed banks’ resolutions – for example, a failure to differentiate different types of uninsured deposits when imposing costs based on banks’ uninsured deposit bases, and a reliance on expensive, penalty-rate discount window loans.
• Non-disclosure agreements and general lack of transparency and public explanation are barriers to public scrutiny, so the full extent of potential mismanagement is unknown. This is unacceptable in public policymaking.

Why it matters: The FDIC’s unexplained decisions may have unnecessarily increased costs, potentially by billions of dollars. The lack of transparency into such policy decisions is a failure of good governance.

What BPI is asking: The FDIC’s Office of Inspector General should investigate concerns about the FDIC’s choices following the spring 2023 bank failures—specifically its administration of the special assessment and ongoing management of the bank receiverships—and make its findings public. In this way, a future FDIC can respond to any future systemic risk event with a better, more transparent approach.

2. Empty Promises: Revisiting the Reasons to Fix the Supplementary Leverage Ratio

Leverage ratios are not risk-sensitive — they treat safe assets like Treasuries the same as higher-risk ones. For this reason, they were designed as complementary backstops to banks’ risk-based capital requirements, ensuring a minimum level of capital even if risk-based requirements prove inadequate. Leverage ratios like the supplementary leverage ratio were not meant to be the binding constraints that determine banks’ required amount of capital. But the SLR has become a more binding constraint for the largest U.S. banks – and this is a problem that policymakers should address, as they previously promised to do.

• The challenge: When a leverage ratio becomes the binding constraint on a bank’s capital allocation, it can ultimately reduce liquidity in important markets. A binding leverage ratio discourages banks from acting as dealers in lower-risk assets like U.S. Treasury securities. This can lower liquidity in such markets as banks retreat from intermediating in those assets.
• Why this problem arose: The SLR has become a more binding constraint on the largest banks for several reasons. A key factor: Growth in safe assets, such as Treasuries and reserves (deposits held at Federal Reserve Banks), has outpaced the growth of banks’ intermediation capacity.
• Promises to revisit: The Fed in 2020 temporarily removed reserves and U.S. Treasuries from the denominator of the SLR calculation for banks. This action came in response to the Fed’s massive purchases of U.S. Treasury securities in response to the market dysfunction caused by the COVID-19 pandemic. By removing cash and Treasuries from the SLR denominator, the Fed effectively lowered the amount of capital banks needed to hold against these assets, freeing up their balance sheets to support the Treasury market and the economy during the crisis. After this temporary action expired in March 2021, the Fed stated that it would soon invite comments on several potential modifications to the SLR. But more than three years later, they have not done so.
  • Both Fed Chair Jerome Powell and Vice Chair for Supervision Michael Barr have expressed support for adjusting the SLR to facilitate Treasury market intermediation.
• Basel context: Under the banking agencies’ original Basel Endgame proposal, the enhanced SLR would be less likely to act as a binding constraint, at least initially, before banks adjust their portfolios in response to its changes. However, recent reports suggest that the banking agencies are likely to make significant changes to the Basel proposal, which will meaningfully increase the likelihood of binding leverage ratios.
• Bottom line: It is critical for the banking agencies to fulfill their promises and release a proposal with the necessary adjustments to SLR and other leverage ratios. These adjustments should ensure that leverage ratios remain the complementary backstops they are designed to be. Failure to do so would mean that banks likely continue to be reluctant to engage in Treasury market intermediation and other similar activities. The current SLR framework is particularly problematic for a financial system that features a bloated central bank balance sheet and substantial reliance on market intermediation.

3. FT Letter to the Editor: Capital without Deposits is Novel Bank Funding Model

BPI Chief Economist Bill Nelson wrote the following letter to the editor, published recently in the Financial Times:

In “Banks will beat Basel III for all the wrong reasons” (Opinion, July 1) Todd H Baker argued that banks should be required to fund themselves with more capital. His argument is premised on the 1958 theorem of Franco Modigliani and Merton Miller, which holds that the total value of an enterprise should be unaffected by how it is financed (in a world with no taxes and perfect information). However, quite strangely for a believer in the theorem, he went on to speculate that banks oppose higher capital because if they were funded with more capital their market value would be lower, perhaps by half.

A true believer in Modigliani and Miller’s theorem would conclude that a bank can be funded with no deposits and all capital with no consequences for its private and social value. The rest of us, perhaps including Baker, need to confront the difficult question of what capital ratio is optimal. No one doubts that capital has the benefit of protecting banks against unexpected losses, but what is the optimal amount. When seeking to avoid the headaches created by bank failures, one aspirin helps, two helps more, but that does not mean you should take the whole bottle.

Moreover, if Modigliani-Miller is a reasonably accurate depiction of reality, then the share price of a bank should be largely unaffected if the bank, say, issues equity and uses it to buy back debt. If bank stocks would fall by as much as Professor Baker speculates if they were funded with more capital, that would be a strong indication that equity financing is expensive, so financing a bank with more of it results in more expensive credit and less economic activity.

As it happens, that trade-off between greater safety and reduced economic activity is precisely how the Basel Committee on Banking Supervision estimated the optimal proportion of capital financing when calibrating Basel III, and how the Bank of England, IMF, and Federal Reserve Board subsequently developed their estimates of the optimal proportion. While these estimates take hard work to develop and are necessarily imprecise, at least they took a stab at it.

4. FDIC Nominee Romero Faces Senate Hearing

Christy Goldsmith Romero, the nominee to replace Martin Gruenberg as FDIC chair, received questions on a wide range of topics on Thursday at her nomination hearing before the Senate Banking Committee. Here are a few key exchanges.

• Basel reproposal: Sen. Mike Rounds (R-SD) asked Romero, a former CFTC commissioner, if she would support reproposing the Basel Endgame proposal. Romero responded that “I think a re-proposal is always on the table when you have a rule that’s proposed and you get that many negative comments” and said she was “open” to a reproposal. Rounds pressed her to commit to recusing herself from voting on the Basel measure if the reproposal needs to move forward and allow Vice Chair Travis Hill to finish the work on it. “I don’t see a reason to recuse, but I can tell you, what I’m trying to explain is: I haven’t seen the changes,” Romero said. “I’m certainly inclined to have a re-proposal whenever there are this many comments and then there’s going to be broad material changes.”
• Qualifications: Ranking Member Tim Scott (R-SC) suggested that Romero lacks the necessary prudential regulatory experience for the job. Other lawmakers were more supportive, but it remains to be seen whether Romero will receive bipartisan support on the Committee.
• Tailoring: Rounds also asked Romero to commit to implementing the S.2155 tailoring law as Congress intended. She said she would comply with it and that “I really believe in the sentiments behind it in terms of tailoring regulation, as we talked about, all banks are not the same.”
• Resolution: Sen. Bill Hagerty (R-TN) questioned Romero about the FDIC’s handling of the spring 2023 failed banks’ resolutions. She responded that she was “looking at it from the outside.” Hagerty asked what role the “least-cost test” played in the failed auctions for Silicon Valley and Signature Banks. He urged Romero to be prepared “on day one” for how to handle the process better. Sen. Katie Britt (R-AL) also asked Romero about how she would handle a failed-bank auction. “Under that scenario, would you commit to accepting the highest bidder that comes to you?” Britt asked. “I think you’d have to go into the very specifics. …You’re looking for the highest bidder, because you want the least cost to the deposit insurance [fund] … Absolutely,” Romero responded.
• Culture: Romero received questions about how she would transform the agency’s culture, which suffers from deep-seated issues as detailed in the recent Cleary Gottlieb report. She cited her experience at other federal agencies and said she would address the longstanding issues, taking steps such as “modernizing culture and modernizing ideas.” “We’re going to go in and go back to reestablishing the FDIC as being a premier regulator,” she said.
• Discount window: Sen. Mark Warner (D-VA) asked Romero if she would work with Fed Chair Powell to address issues with the Fed’s discount window. She agreed and acknowledged the importance of the window, citing her experience leading the Office of the Special Inspector General for the Troubled Asset Relief Program during the Global Financial Crisis. Reducing the stigma of the discount window and ensuring banks are prepared to use it is “worth taking the time to do,” she said.

5. CFPB Floats Eliminating Credit Card Fee ‘Safe Harbor’

The CFPB in its recently published long-term regulatory agenda suggested it may seek to eliminate the safe harbor for credit card late fees. In the bipartisan CARD Act legislation, Congress authorized the CFPB to create a safe harbor – under which banks are permitted to charge certain credit card penalty fees, like late fees, up to a certain threshold. The CFPB’s credit card late fee rule, which BPI has noted is based on flawed and distorted analysis and would ultimately harm consumers’ credit access, would drastically reduce that safe harbor to $8. Any elimination of the safe harbor would presumably come in response to the banking industry’s ongoing legal challenge against the credit card late fee rule.

• Relevant quote: “In the future, and considering the status of the March 2024 Rule and market conditions, the CFPB will assess the efficacy of the regulatory landscape and whether the regulatory safe harbor is outdated and should be eliminated.”
• Statutory authority: In the document, the CFPB said “[a]uthority to amend this safe harbor transferred to the CFPB pursuant to sections 1061 and 1100A of the Consumer Financial Protection Act of 2010.”

In Case You Missed It

Lawmakers Flag Potential Conflict Between State Laws, Federal AML Framework

Reps. Josh Gottheimer (D-NJ), Blaine Luetkemeyer (R-MO) and Brad Sherman (D-CA) expressed concern to Treasury Secretary Janet Yellen, FinCEN Director Andrea Gacki and OCC Acting Comptroller Michael Hsu this week about tensions between state laws that scrutinize banks when they decline to provide services or close a customer account and the federal anti-money laundering framework. Such laws “risk fracturing the national banking system,” the lawmakers wrote in a letter. They could also undermine U.S. efforts to fight financial crime and safeguard against terrorism, according to the letter. Specifically, the laws – which would require banks to explain the reasons for an account closure to states or even individual customers – could force disclosure of confidential national security information; federal AML law prohibits banks from revealing the existence or non-existence of a Suspicious Activity Report. Banks “should not face pressure or state actions when they take actions to control financial crime risk consistent with these federal standards,” the lawmakers wrote.

Treasury’s Liang Explores How to Make Stressed Markets More Resilient

U.S. Treasury Under Secretary for Domestic Finance Nellie Liang addressed aspects of the macroprudential framework this week in a speech. Liang suggested potential improvements to the countercyclical capital buffer (or CcyB). She said: “There could be better communication to banks about the goals of the CcyB and the simplicity of using it, and seek to assuage banks’ concerns about possible negative reactions from supervisors.” Liang also observed that authorities may be slow to activate the CcyB until it is too late and financial stability risks are already too high.

• Leverage ratio: Liang emphasized the need to guard against the risks of nonbank firms’ fragility. She alluded to the nonbank financial sector’s distress during the COVID pandemic and referred to ongoing U.S. efforts to increase Treasury market liquidity. “Another proposal to consider would be a countercyclical element to the leverage ratio for banking firms to support market-making in low-risk securities when stress erupts,” she said. A footnote in this part of the speech refers to a 2020 paper by Liang and Patrick Parkinson (a BPI senior fellow), which proposed to replace some or all of the current buffer requirement for the enhanced supplementary leverage ratio with a countercyclical component that the Fed could release during stress to reduce the leverage ratio’s constraints on market making. That paper also proposed permanently excluding reserves at the central bank from the SLR.
• Context: As BPI noted in a recent blog post, described in detail in a separate summary above, the supplementary leverage ratio has recently become more of a binding constraint for large banks, rather than the backstop it is intended to be. This problem can reduce liquidity in important markets like the Treasury market.
• Excess reserves: At a Congressional hearing this week, Rep. Frank Lucas (R-OK) asked Treasury Secretary Janet Yellen if she agreed that certain reforms to the leverage ratio could improve U.S. Treasury market participation. He noted that Liang has suggested excluding excess reserves held at the Fed from the leverage ratio during market stress. Yellen responded: “That certainly is a reform that was worthy of discussion and I at the time thought it was very appropriate to take that step and would be supportive of greater liquidity in the Treasury market. But, again, this is a decision for the banking regulators … I would hope that they would take this into account.”

The Crypto Ledger

Here’s the latest in crypto.

• Digital assets oversight: Nellie Liang, under secretary for domestic finance at the U.S. Treasury Department, addressed digital asset regulation in a recent speech. Stablecoin oversight could take the form of either nonbank regulation or banking regulation. Under a bank model, stablecoins could be backed by bank assets and capital and liquidity buffers. However, “because banks are at the center of the financial system, it would be especially important to ensure that safeguards are in place to prevent significant losses for the bank or its customers in this model.” A nonbank model would require both a 1:1 safe-asset backing requirement and capital, liquidity and other prudential standards, Liang said.
• Russian sanctions evasion: Russian central bank chief Elvira Nabiullina recently encouraged the use of crypto to avoid sanctions, according to Reuters.
• BitMEX guilty plea: Crypto exchange BitMEX pleaded guilty this week to violating the Bank Secrecy Act, according to the U.S. Department of Justice. The Seychelles-based crypto platform failed to set up an adequate know-your-customer and anti-money laundering program.