FDIC Vice Chair Urges Partitioning of Nonbanking Activities

FDIC Vice Chair Thomas Hoenig discussed his recent proposal to require that banks partition certain nonbanking activities (see previous coverage for more detail).

At a Conference on Systemic Risk and Organization of the Financial System held at Chapman University, California, Mr. Hoenig described a shift in the banking industry towards consolidation among the largest banks. He noted some of the key factors that have led to this trend: (i) technological developments and financial engineering, (ii) 1990s legislation easing the strain of banking regulations, (iii) significant mergers of commercial and investment banks, and (iv) fallout from the 2008 financial crisis, including the introduction of the Dodd-Frank Act in 2010.

Mr. Hoenig noted that, while the Dodd-Frank Act included some structural changes (such as the Volcker Rule), Congress, in large part, chose “regulatory control over structural change.” Mr. Hoenig warned that such over-reliance on regulation potentially could slow down economic growth. He instead advocated for structural change, suggesting that:

“. . . universal banks would partition their nontraditional activities into separately managed and capitalized affiliates. The safety net would be confined to the commercial bank, protecting bank depositors and the payment system so essential to commerce. Simultaneously, these protected commercial banks would be required to increase tangible equity to levels more in line with historic norms, and which the market has long viewed as the best assurance of a bank’s resilience.”

Mr. Hoenig recommended implementing a variety of other safeguards to supplement the partition, such as setting limits on the amount of debt the ultimate parent companies could downstream to subsidiaries. He also mentioned the possibility that, by allowing for resolution through bankruptcy, his proposal could reduce regulatory burdens, including the elimination of risk-based capital and liquidity, the Comprehensive Capital Analysis and Review, Dodd-Frank Act Stress Testing, the Orderly Liquidation Authority, Living Wills, and parts of the Volcker Rule.

Lofchie Comment: One problem with the proposal is the distinction it makes between traditional and nontraditional activities. This distinction is based upon the time in which a particular type of financial activity was created and the substance of the activity. For example, entering into swap transactions (particularly as to rates and currencies) and clear swaps and futures should be viewed as core banking activities: they are activities that are completely about credit intermediation. To assert that they are not “traditional” banking activities because they were not done in the 1950s or the 1850s would be not so different from stating that email is not a traditional form of bank communication. It may not be traditional, but it is the modern version of the telephone, and it is core to what banks do.

OCC Publishes Revised Sections of Comptroller’s Licensing Manual

The Office of the Comptroller of the Currency (“OCC”) published revised versions of the “Public Notice and Comments” and “Fiduciary Powers” booklets of the Comptroller’s Licensing Manual.

The “Public Notice and Comments” booklet provides information about public notice requirements and procedures. The revised version replaces the booklet published in March 2007. The “Fiduciary Powers” booklet outlines policies and procedures for banks and federal savings associations exercising fiduciary powers. The revised version replaces the booklet published in June 2002.

Comptroller of the Currency Steps Down, Expresses OCC’s Continuing Commitment to Innovation

Comptroller of the Currency Thomas J. Curry announced that he will step down from his position on May 5, 2017. In a speech at the “Fintech and the Future of Finance Conference,” at the Kellogg School of Management, Northwestern University, Mr. Curry reaffirmed the continuing commitment of the Office of the Comptroller of the Currency (“OCC”) to facilitate innovation. He acknowledged the growing impact of FinTech companies, as well as the potential complications that accompany their continued progress and advancement.

In his remarks, Mr. Curry reviewed the OCC process that led to proposals for granting national bank charters to certain FinTech companies. In response to the rapidly expanding FinTech sector, Mr. Curry explained, the OCC launched a “responsible innovation initiative,” which was intended to ensure cooperation between regulators, traditional bankers, FinTech companies and other relevant entities. The initiative, which explored obstacles to innovation and considered regulatory support measures, eventually devised a solution of granting national bank charters to certain FinTech companies. To that end, the OCC published a draft supplement to the Comptroller’s Licensing Manual on March 15, 2017 that detailed the process of evaluating bank charter applications from FinTech companies. Mr. Curry addressed the opposition to these special purpose charters by advising restraint:

“At the heart of the issue is the fundamental nature of the business of banking – the business of banking is dynamic and I would urge caution to anyone who wants to define banking as a static state. Such a view risks choking off growth and innovation. The federal banking system has served as a common source of strength for communities across the country and for the broader national economy for more than 150 years because it was allowed to adapt to meet the evolving need of consumers, business, and communities.”

Mr. Curry also touted the OCC’s new Office of Innovation, and claimed that it will have an even greater impact on the industry than the FinTech charters, since it will serve to analyze all areas of financial innovation and eventually provide consistent, confidential regulatory advice. He emphasized that the Office of Innovation was put in place to support banks and FinTech companies, and to provide evolving guidance as new opportunities for collaboration and advancement arose.

Mr. Curry – who completed his five-year term as Comptroller on April 9, 2017 – will step down from his position on May 5, 2017. Keith A. Noreika will serve as Acting Comptroller.

FDIC Publishes Handbook for Organizers of New Depository Institutions

The FDIC published a handbook for new depository institutions. The handbook was designed to help potential organizers become familiar with the deposit insurance application process and the path by which to obtain deposit insurance. The handbook offers, among other things, guidance on the three phases of establishing an insured institution: pre-filing activities, the application process and pre-opening activities.

Lofchie Comment: What is interesting about this publication is that it would seem to have no readership. There are virtually no new banks. See Federal Reserve Bank of Richmond, “Explaining the Decline in the Number of Banks since the Great Recession“; see also George Sutton, “What Dearth of New Banks Means for the Industry’s Future” (American Banker). Thus, the really significant question is not how does one start a new bank, but, rather, why does no one want to do so?

NY Fed Bank President Says It’s Time to Evaluate Post-Crisis Regulatory Regime, Questions Effectiveness of Volcker Rule

Federal Reserve Bank of New York (“NY Fed”) President and CEO William C. Dudley articulated several principles to consider when evaluating the post-financial crisis regulatory regime and raised questions about the effectiveness of the Volcker Rule.

Mr. Dudley stated that the financial crisis exposed flaws in the regulatory framework – in particular, capital and liquidity inadequacies at large financial institutions. He cited “a number of important structural weaknesses that made it vulnerable to stress” including: (i) systemically important firms operating without sufficient capital and liquidity buffers, (ii) risk monitoring, measuring and controlling failures, (iii) significant problems in funding and derivatives markets, and (iv) fundamental defects in the securitization markets. These weaknesses, he noted, were “magnified by the lack of a good resolution process for large, complex financial firms that got into trouble.”

Mr. Dudley argued that while the industry “must resolve to never allow a return to [pre-crisis] conditions,” now is an appropriate time to begin evaluating the changes that were made to the regulatory regime. He articulated three principles to keep in mind for an effective regulatory regime:

  1. “Ensure that all financial institutions that are systemically important have enough capital and liquidity so that their risk of failure is very low, regardless of the economic environment.”
  2. “Have an effective resolution regime that allows such firms to fail without threatening to take down the rest of the nation’s financial system, and without requiring taxpayer support.”
  3. Ensure that the financial system remains resilient to shocks by preserving “the centralized clearing of over-the-counter (OTC) derivatives, better supervision and oversight of key financial market utilities, and the reforms of the money market mutual fund industry and the tri-party repurchase funding (“repo”) system.”

Mr. Dudley suggested that regulatory and compliance burdens could be made “considerably lighter” on smaller and medium-sized banking institutions because “the failure of such a firm will not impose large costs or stress on the broader financial system.”

Mr. Dudley also questioned whether the implementation of the Volcker Rule was achieving its policy objectives. Regulating entities under the Volcker Rule is difficult, he argued, because most market-making activity has “an element of proprietary trading” and the division between market-making and proprietary trading is “not always clear-cut.” Mr. Dudley said that while the evidence may be inconclusive, the Volcker Rule could be responsible for a decline in market liquidity of corporate bonds. Mr. Dudley strongly recommended Volcker exemptions for community banks.

Lofchie Comment: Mr. Dudley notes that the profitability of banks has dropped in light of their reduced leverage, but he asserts that they remain “profitable enough to cover their cost of capital.” What makes this remark particularly notable is the contrasting recent assertion of FDIC Vice-Chair Thomas Hoenig who claimed that (i) banks’ return on equity was low because they were too highly leveraged (a completely counterintuitive assertion that Mr. Hoenig did not fully explain) and (ii) that banks were less profitable than essentially every other industry (which would seem to suggest that banks were not profitable enough to cover their costs of capital, or at least that investors’ capital was better deployed elsewhere). Whatever is causing the decline in bank profitability (leverage too high or leverage too low), bank regulators should worry that the firms that they regulate are not making enough money to sustain themselves for the long term.

President Trump Directs Treasury Secretary to Reconsider Two Dodd-Frank Authorities

In two executive memoranda, President Donald J. Trump directed the U.S. Department of the Treasury to review key elements of the Dodd-Frank post-crisis regulation. The memoranda authorizes the Treasury Secretary to review (i) the processes of the Financial Stability Oversight Council (“FSOC”) for designating “systemically important” institutions, and (ii) the Orderly Liquidation Authority (“OLA”) including a review of potentially adverse consequences posed by the framework.

In a statement, Treasury Secretary Steven Mnuchin said that during the review process, the Treasury will not designate any new non-bank financial institutions as systemically important under the FSOC. The goal of the review, he said, is to “make this a smarter, more effective process that reduces the kinds of systemic risk that harmed so many Americans during the financial crisis of 2008.”

Secretary Mnuchin said that the review of the OLA will attempt to determine (i) whether the OLA is encouraging “inappropriate risk-taking,” (ii) “the extent of taxpayer liability,” and (iii) how the bankruptcy code “may be a more appropriate avenue of resolving financial distress.”

President Trump remarked:

“I’m . . . issuing two directives that instruct Secretary Mnuchin to review the damaging Dodd-Frank regulations that failed to hold Wall Street firms accountable. . . . These regulations enshrine ‘too big to fail’ and encourage risky behavior.”

 

Lofchie Comment: Politically, these executive actions are promoted as being for the purpose of holding Wall Street accountable. The larger benefit they provide is to put a check on the very broad discretionary powers afforded the government under Dodd-Frank. These executive actions move financial regulation back toward a system of rules governed by written procedures and not by grants of broad discretion.

House Republicans Release Revised CHOICE Act

House Republicans released the Financial CHOICE Act of 2017. The bill is an update of the CHOICE Act of 2016. The new version represents a major overhaul of the current financial services regulatory regime including a partial repeal of Dodd-Frank.

In September 2016, the House Financial Services Committee approved the initial version of the CHOICE Act by a vote of 30 to 26. At a hearing scheduled for April 26, 2017, the Committee will discuss the updated version of the bill. Proposed changes to the current financial regulatory regime include, among other things:

  1. an opt-out of many regulatory requirements for banks and other financial institutions if they maintain a 10% leverage ratio (among other conditions);
  2. subjecting the federal banking agencies to greater congressional oversight and tighter budgetary control;
  3. materially reducing the authority of the Financial Stability Oversight Council and the establishment of a new process of identifying financial institutions as “systemically important”;
  4. a repeal of the Orderly Liquidation Authority and the creation of a new bankruptcy process for banks;
  5. reforms in bank stress tests;
  6. a restructuring of the CFPB, FHFA, OCC, and FDIC into bipartisan commissions appointed by the President;
  7. the elimination of the CFPB supervisory and examination authority;
  8. a repeal of the Volcker Rule; and
  9. facilitated capital raising by small companies, including through crowd-funding.

The Committee released a summary of changes.

Regarding derivatives, the new legislation exempts certain inter-affiliate swaps from nearly all Title VII requirements (except reporting), and otherwise removes a number of changes to Title VII that were previously included (it is suggested that this is because such provisions would be addressed in CFTC reauthorization legislation).

Chairman Jeb Hensarling (R-TX) called the bill a solution that “grows our economy from Main Street up.” He asserted that the CHOICE Act is premised on the principles that all banks need to be well-capitalized and that community banks and credit unions deserve relief from the “crushing burden of over-regulation.”

Lofchie Comment: Changes that the bill would make in the regulatory process are genuinely significant. These are largely in Title III of the proposal (see page 104).

Under the terms of the bill, the various financial regulators (including the banking regulators, the CFTC and the SEC) would be prohibited from issuing a “regulation” (which term would be broadly defined) unless the regulator first issued a statement (i) stating the need for the regulation, (ii) explaining why the private market could not address the problem, (iii) analyzing the adverse impacts of the regulation, and (iv) attempting to quantify the costs and benefits of the regulation, including its effects on economic activity, the basis for its determinations, and, most significantly, “an explanation of predicted changes” that will be brought about by the regulation.  A final rulemaking would be required to include “regulatory impact metrics selected by the [regulator’s] chief economist.”

Adherence to this process would make the tasks of the regulator materially more difficult, or at least it would make it more difficult for the regulators to pass rules. Of course, there is a significant amount of good in that. Regulators should be subject to a reasonably high burden of consideration in adopting rules that may cost market participants, in the aggregate, millions of dollars in compliance costs or that have negative effects on the economy generally.

One of the most interesting provisions of the bill is the requirement that regulators should provide an explanation of predicted changes that will result from the rule. Doubtless, in many cases, the predictions will turn out to be wrong. But that is ok. It is unreasonable to expect that regulators will be always, or even that consistently, correct in their predictions. The new standard may be hard to assess, but the attempt is still worthwhile.

CFPB Fair Lending Report Summarizes Remediation Results and Priorities

The Consumer Financial Protection Bureau (“CFPB”) published its fifth Fair Lending Report. The CFPB highlighted its efforts to protect consumers from market abuses, as well as its remediation results and priorities for 2017.

The report identified a number of approaches and outcomes related to the CFPB’s 2016 fair lending initiatives, including:

  • risk-based prioritization in supervisory and enforcement work,
  • results from enforcement actions, which produced $46 million for consumers,
  • an update on Regulation C (“Home Mortgage Disclosure”) and the CFPB’s dialogue with the industry regarding compliance,
  • interagency efforts to ensure the active supervision and enforcement of the fair lending laws and regulations, and
  • CFPB outreach initiatives to reach stakeholders about issues concerning access to credit.

CFPB Director Richard Cordray said that the three goals of the Bureau in this area are to “strengthen industry compliance programs, root out illegal activity, and ensure that harmed consumers are remediated.” He praised the CFPB’s “significant efforts,” and added that the Bureau had reached an “historic resolution” of large cases involving redlining, auto finance and credit card fair lending.

CFPB Office of Fair Lending and Equal Opportunity Director Patrice Alexander Ficklin reported that in 2017, the Office will strengthen its focus on redlining and mortgage, student loan servicing, and small business lending.

Lofchie Comment: Given that many of the CFPB’s actions do not reflect current executive or legislative policy, the CFPB’s report on the direction of its intended activities brings home a difficult Constitutional issue: to what branch of the government does the CFPB belong? It is not judicial. It is not funded directly by Congress. And it does not report to the President. It is clearly more “independent” than the other independent agencies, such as the SEC or the CFTC (whose Chairpersons are named by the President), but its extreme independence forces the question of where independent agencies (including even the SEC and the CFTC) fit generally within the Constitutional scheme of a tripartite government.

FDIC Vice Chair Blames Low Bank Profitability on Debt/Equity Ratio

The FDIC released a semi-annual report of the Global Capital Index. FDIC Vice Chair Thomas Hoenig described the results, noting that equity capital ratios increased at most of the largest U.S. banks.

Vice Chair Hoenig maintained that, while the report reveals improvements in capital ratios, the banking sector remains highly leveraged and provides the lowest return on equities when compared with other major U.S. industries. He expressed concern that capital ratios at the largest U.S. banks “remain too low,” which is “undermining long-term economic growth.”

Lofchie Comment: The notion that banks would improve their return on equity if they had a higher percentage of equity seems counterintuitive. The “proof” that Vice Chair Hoenig offers for this assertion is that other industries that have higher ROEs are less highly leveraged. The argument that a bank would make the same profits as a consumer/discretionary company if only it had the same debt/equity ratio does not seem compelling. There are reasons other than high leverage why banks’ ROE might be low: for example, heavy regulatory costs and being forced out of existing business activities; e.g., the Volcker Rule. Perhaps Vice Chair Hoenig’s theory is correct, but other possible theories should be considered.

Report on Repo Market Financing Raises Concerns

The Bank for International Settlements (“BIS”) published a Report that found that changes in the availability and cost of repurchase agreement (“repo”) financing are affecting the ability of repo markets to support the financial system. The Report was prepared by a study group organized by the BIS Committee on the Global Financial System (“CGFS”) that included staff members from international regulatory agencies, the Board of Governors of the Federal Reserve System and the New York Fed.

The study group examined repo transactions backed by government bonds and concluded that banks in some jurisdictions appear to be less willing to undertake repo market intermediation than they were before the crisis. Key “drivers” behind these changes include “exceptionally accommodative monetary policy” and regulatory changes that have made intermediation more costly. However, the study group cautioned that it would be premature to establish correlations between policy changes and changes in the market given “differences in repo markets across jurisdictions and the fact that repo markets are in a state of transition.”

To improve repo market functioning, the study group recommended that a series of temporary measures be implemented, including steps to reduce the “scarcity of certain collateral.”

Lofchie Comment: It seems regulators are beginning to acknowledge that new regulations may have had some negative effects on the financial markets, financial market participants, investors and the economy. Seee.g.Federal Reserve Governor Daniel Tarullo Reconsiders the Volcker RuleComptroller Reviews Regulatory Environment for Community Banks and Mutual Associations. This is a welcome development. It is the start of a conversation about the fact that some rules do more harm than good and that not every examination of a rule has to be a partisan or political event.