Federal Reserve Board Governor Powell Advocates Additional Regulatory Reform

At the Salzburg Global Seminar, Federal Reserve Board Governor Jerome H. Powell lauded the progress made by the U.S. financial system since the financial crises, particularly in the increased liquidity and improved loss-absorbing capacity of banks. Mr. Powell identified five “key areas” that would benefit from additional regulatory reform:

  • Small banks: Continue to improve regulations governing call reports and the frequency of examinations by simplifying the general capital framework for community banks.
  • Resolution plans: Extend the living will submission cycle from once a year to once every two years, and focus every other filing on key topics of interest and material changes from the previous year.
  • Volcker Rule: Work together with the other four Volcker Rule agencies to reevaluate the rule and ensure that it delivers policy objectives effectively.
  • Stress testing: Evaluate stress testing and comprehensive capital analysis and review, including through public feedback, in order to improve transparency of process.
  • Leverage ratio: Reexamine enhanced supplementary leverage ratio in order to adhere to the proper calibration of leverage ratio and risk-based capital requirements.

 

Treasury Gets Specific, Recommends Significant Regulatory Reform

The U.S. Treasury Department (“Treasury”) released a report pursuant to President Trump’s February Executive Order establishing core principles for improving the financial system (see previous coverage). Drafted under the direction of Treasury Secretary Steven T. Mnuchin, the report is the first of a four-part series on regulatory reform and covers the financial regulation of depository institutions. Subsequent reports will focus on areas including markets, liquidity, central clearing, financial products, asset management, insurance and innovation.

The report contained the following Treasury recommendations, among others:

  • Capital and Liquidity: (i) raise the threshold for participation in company-run stress tests to $50 billion in total assets (from the current threshold of more than $10 billion), (ii) tailor the application of the liquidity coverage ratio appropriately to include only global systemically important banks and internationally active bank holding companies, and (iii) remove U.S. Treasury securities, cash on deposit with central banks, and initial margin for centrally cleared derivatives, from the calculation of leverage exposure.
  • Volcker Rule: modify the Volcker Rule significantly, by (i) providing a full exemption for banks with $10 billion or less in total assets, and (ii) evaluating banks with greater than $10 billion in total assets based on the volume of their trading assets. Treasury also recommended a number of other measures to reduce regulatory burdens and simplify compliance, such as further clarifying the distinction between proprietary trading and market-making.
  • Stress Testing: increase the asset threshold from $10 billion to $50 billion, and allow regulatory agencies to make discretionary decisions for a bank with more than $50 billion in assets based on “business model, balance sheet, and organizational complexity.”
  • Consumer Financial Protection Bureau (“CFPB”): restructure the CFPB to provide for accountability and checks on the power of its director, or subject the agency’s funding to congressional appropriations. (Treasury criticized the “unaccountable structure and unduly broad regulatory powers” of the CFPB, and concluded that the structure and function of the agency has led to “regulatory abuses and excesses.”)
  • Residential Mortgage Lending: ease regulations on new mortgage originations to increase private-sector lending and decrease government-sponsored lending.

Treasury also outlined its support for the idea of creating an “off-ramp” from many regulatory requirements for highly capitalized banks. This approach would require an institution to elect to maintain a sufficiently high level of capital, such as a 10% non-risk weighted leverage ratio.

Lofchie Comment: At last, a regulatory discussion that says something more than “there was a financial crisis, so there must be more rules, and more rules will make us safer.” This report reads as if it was informed by real work experience. It is a recognition of both the costs and benefits of financial regulation.

The report is not an attack on government. While critical of Dodd-Frank, Treasury acknowledges the better aspects of it, particularly improvements in bank capital ratios. In sum, Treasury is making the point that Dodd-Frank is seven years old; hundreds of rules have been adopted under it, and the time has come to see what aspects of it are working or not. (If there is anyone out there who believes after seven years of Dodd-Frank that it’s all going swimmingly, that person is just not paying attention.)

The biggest question is whether those who have disagreements with the recommendations will argue why the particulars are wrong, or whether the debate will simply be about the evils of Wall Street and the Administration. After seven years of Dodd-Frank (did someone break a mirror?), it really is time to talk specifics.

House of Representatives Passes Financial CHOICE Act

On June 8, 2017, the House of Representatives passed the “Financial CHOICE Act of 2017” (H.R. 10) (the “CHOICE Act”). The vote was 233 to 186, largely along partisan lines. The CHOICE Act had been approved by the House Financial Services Committee on May 4, 2017. The bill is a major overhaul of the current financial services regulatory regime including a partial repeal of Dodd-Frank. (For previous Cabinet coverage of general provisions of the bill, see House Republicans Release Revised CHOICE Act.)

Financial Services Committee Chair Jeb Hensarling (R-TX) stated that the CHOICE Act would have a significant impact on the economic wellbeing of the United States:

“[The CHOICE Act] stands for economic growth for all, but bank bailouts for none. We will end bank bailouts once and for all. We will replace bailouts with bankruptcy. We will replace economic stagnation with a growing, healthy economy.”

Economists Say Fed Report Shows Improved Bank Loan Portfolio Performance

In an article posted on the Liberty Street Economics blog of the Federal Reserve Bank of New York (“NY Fed”), authors James Vickery and April Meehl concluded that the latest NY Fed Report Quarterly Trends for Consolidated U.S. Banking Organizations demonstrates significant improvement in the performance of bank loan portfolios over the past few years.

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.