House Subcommittee Considers AML De-Risking

The U.S. House Subcommittee on Financial Institutions and Consumer Credit considered testimony regarding the implications of “de-risking,” wherein financial institutions end relationships and close the accounts of “high-risk” clients to avoid legal liability and regulatory scrutiny. The subcommittee noted that de-risking (i) may affect “many legitimate businesses,” (ii) could reduce access by small businesses to financial products domestically, and (iii) could affect the flow of humanitarian aid globally.

Witnesses at the hearing included Michael E. Clements, Director of Financial Markets and Community Investment of the Government Accountability Office (“GAO”); Sue E. Eckert, Adjunct Senior Fellow at the Center for a New American Security; Gabrielle Haddad, Chief Operating Officer of Sigma Ratings Inc.; John Lewis, Senior Vice President of Corporate Affairs and General Counsel at the United Nations Federal Credit Union on behalf of the National Association of Federally-Insured Credit Unions; and Sally Yearwood, Executive Director of Caribbean-Central American Action.

GAO Reports

Mr. Clements based his testimony on GAO reports from February 2018 and March 2018. He stated that Bank Secrecy Act/Anti-Money Laundering (“BSA/AML”) regulations have been a factor for some banks in terminating or limiting accounts and closing branches. The February report found that certain geographic areas were more likely to lose bank branches if they were (i) urban and had higher per capita personal incomes and younger populations, or (ii) designated as High-Intensity Financial Crime Areas or High-Intensity Drug Trafficking Areas, or featured higher rates of banks filing suspicious activity reports. According to the February report, approximately 80% of U.S. Southwest border region banks, due to increased BSA/AML oversight, either limited or did not offer accounts to customers considered to be at high risk for money laundering. According to the March report, money transmitters in Haiti, Liberia, Nepal and Somalia (collectively, “fragile countries”) reported a significant loss of banking access and increased reliance on nonbanking channels as alternatives.

The February report urged the Financial Crimes Enforcement Network, the FDIC, the Federal Reserve and the Office of the Comptroller of the Currency to conduct a retrospective review of BSA/AML regulations and their implications for banks. The March report advised the U.S. Treasury Department (“Treasury”) to analyze how “shifts in remittance flows from banking to non-banking channels for fragile countries may affect the Treasury’s ability to monitor for money laundering and terrorist financing.”

Testimony and Recommendations

Mr. Lewis testified that financial institutions may de-risk themselves in response to examiners who go beyond what is required by guidance, or in response to broad law enforcement requests for information about particular types of customers. He said that additional pressure from examiners and the threat of overbroad investigatory demands are both factors in de-risking decisions. Mr. Lewis recommended (i) implementing a “safe-harbor” policy for financial institutions that provides services to high-risk accounts if the financial institutions conduct sufficient scrutiny of the accounts, (ii) educating financial institutions on risk-based review requirements and (iii) amending regulations so that a financial institution is not “the ‘de facto’ regulator of a business.”

Ms. Yearwood recommended that (i) the Treasury continue providing assistance to Caribbean nations (a high-risk region), (ii) regulations be harmonized to better enable small countries with limited capacities to remain compliant, (iii) investments in new technology be made to “level the playing field” and (iv) regulations be recalibrated when they are weighted against smaller economies.

Ms. Haddad recommended (i) improving the sharing of risk information between the private and public sectors to enhance overall transparency, (ii) using third-party providers to conduct assessments of respondent banks’ compliance with global standards, and (iii) using technology to lower AML and other related compliance costs without threatening financial institutions with regulatory backlash.

Ms. Eckert testified that the “de-risking phenomena” restricted financial access for non-profit organizations with “deleterious humanitarian consequences.” Ms. Eckert called for U.S. leadership to ensure the flow of humanitarian funds.

Lofchie Comment: Well-intended rules may have negative consequences. In this case, the potential fines — and the potential for public embarrassment for accepting an account that appears in any way AML-uncertain — far outweigh any ordinary business gain from accepting the account. It is not so clear how the regulators can be very tough on AML failures and at the same time motivate financial institutions to accept accounts that appear in any way AML-risky.

Federal Judge Determines that the CFPB Is “Unconstitutionally Structured”

The U.S. District Court for the Southern District of New York (“S.D.N.Y.”) dismissed Consumer Financial Protection Bureau (“CFPB”) claims based on the determination that the CFPB “lacks the authority to bring [these] claims” because it is “unconstitutionally structured.”

In the Opinion and Order, the S.D.N.Y. disagreed with the en banc holding of the D.C. Court of Appeals (the “Court of Appeals”) in PHH Corp. v. CFPB, which upheld the CFPB’s constitutionality under Title X of the Dodd-Frank Act. Judges Brett Kavanaugh and Karen LeCraft Henderson issued dissenting opinions in PHH Corp., which the S.D.N.Y. partially adopted in its decision. The S.D.N.Y. affirmed that, as stated in Judge Kavanaugh’s Opinion, the CFPB “is unconstitutionally structured because it is an independent agency that exercises substantial executive power and is headed by a single Director.” Furthermore, the S.D.N.Y. adopted Judge Henderson’s dissenting opinion, which argued that the entirety of Title X of Dodd-Frank should be stricken.

The S.D.N.Y. also rejected the argument within the Notice of Ratification (filed on May 11, 2018) that Acting Director Mick Mulvaney’s ratification dismisses any grounds upon which the CFPB’s constitutionality can be questioned. The Notice of Ratification debated that, because President Trump could remove Mr. Mulvaney at will, there are no longer grounds for an argument that the CFPB violates the Constitution’s separation of powers. The S.D.N.Y. stated that the Notice of Ratification failed to “render[] Defendants’ constitutional arguments moot.”

Lofchie Comment: Given the divide between the courts as to the constitutionality of the CFPB, one might ordinarily expect the government to appeal this decision. However, many members of the administration are likely in agreement with the S.D.N.Y. determination that the CFPB is not constitutionally established. It is not certain how the government will react.

That said, there is no justification for giving a single person – the head of the CFPB – such a tremendous amount of power, without subjecting the individual to any checks, whether that be the Presidential power to dismiss the individual, Congressional power to limit the CFPB’s budget, or the power of other Commissioners to dissent to actions taken by the CFPB. Hopefully, the Court’s decision will motivate Congress to improve the structure of the CFPB and to dampen the remarkable and unseemly authority granted to the agency’s head.

Treasury Department Researchers Analyze Form PF Data

Researchers at the U.S. Treasury Department’s Office of Financial Research (“OFR”) analyzed information gathered from Form PF and described trends in the activities of private equity funds and their controlled portfolio companies (“CPCs”). As stated in a recent SEC comment request, “Form PF is designed to facilitate the Financial Stability Oversight Council’s (“FSOC”) monitoring of systemic risk in the private fund industry and to assist FSOC in determining whether and how to deploy its regulatory tools with respect to nonbank financial companies.” Investment advisers with greater than $150 million in private fund assets under management are required to provide information on Form PF, such as (i) the funds they advise, (ii) private fund assets under management, (iii) fund performance and (iv) the use of leverage.

The OFR researchers found:

  • borrowing and leverage increased among certain CPCs from 2013 to 2016, which could signal a greater likelihood of default;
  • some CPCs had significant short-term debt exposures, which “should continue to be monitored”; and
  • investment in financial CPCs has shifted toward non-bank entities.

The analysis, published in the OFR Brief Series, stated that the views and opinions of the authors do not necessarily represent the views of the OFR or the U.S. Department of the Treasury.

Lofchie Comment: The report concludes as follows:

“Form PF is not a perfect tool for monitoring trends in the private equity industry. The data collection lacks a long history, and reporting errors persist. Still, the analysis in this brief illustrates that Form PF data can be useful for monitoring basic fund characteristics. . . .”

There is only so much that analysts can do with data that is both limited and flawed. The report itself contains some moderately informative background as to the state of the private equity industry. However, observations such as “if a company borrows more money, then it is more likely to default” do not really add much to the government’s ability to understand financial markets or systemic risk.

The government would be better off scrapping Form PF and trying to understand why the process of creating it went so wrong. This is not intended as a criticism of the report’s authors. It is just the reality of so-so in, so-so out.

FinCEN Calls Attention to Transactional Red Flags Associated with International Corruption

The U.S. Treasury Department Financial Crimes Enforcement Network (“FinCEN”) issued an advisory describing how corrupt foreign “politically exposed persons” (“PEPs”) access the U.S. financial system. The advisory provides guidance on the (i) risks that U.S. financial institutions face when providing banking services to PEPs and their financial facilitators and (ii) types of suspicious transactions that may trigger reporting obligations under the Bank Secrecy Act.

The advisory includes the following non-exclusive list of red flags that may help identify methods used to hide the proceeds of human rights abuses and other illicit international activities:

  • using third parties when it is not normal business practice;
  • using third parties to shield the identity of a PEP;
  • using family members or close associates as legal owners;
  • using corporate vehicles such as limited liability companies (LLCs) to hide ownership, involved industries or countries;
  • receiving information from PEPs that is inconsistent with publicly available information;
  • transactions involving government contracts that (i) are awarded to companies in a seemingly unrelated line of business, or (ii) originate from or are going to shell companies that appear to lack a general business purpose;
  • documents supporting transactions regarding government contracts that include (i) charges that are higher than market rates, (ii) overly simplistic information or (iii) insufficient detail;
  • payments connected to government contracts that come from third parties that are not official government entities; and
  • transactions involving property or assets expropriated or otherwise taken over by corrupt regimes, including senior foreign officials or their cronies.

The advisory also provides examples of suspicious activities by PEPs and their financial facilitators, such as:

  • moving funds repeatedly to and from countries with which the PEP does not have ties;
  • requesting to use services of a financial institution or a designated non-financial business or profession (“DNFBP”) not normally associated with foreign or high-value clients;
  • holding substantial authority over or access to state assets and funds, policies and operations; and
  • controlling the financial institution or DNFBP that is a counterparty or correspondent in a transaction.

The advisory indicated that FinCEN would update these red flags and typologies in the future, and reminded financial institutions of their obligation to identify suspicious transactions and file suspicious activity reports (SARs) under the Bank Secrecy Act.

Banking Agencies Issue Statement on Enforcement Coordination

The Office of the Comptroller of the Currency, the FDIC and the Board of Governors of the Federal Reserve System (“Agencies”) issued an updated policy statement on coordination among the federal banking agencies during formal enforcement actions. The text of the statement was published in the Federal Register. The statement reflects the recent rescission of the Federal Financial Institutions Examination Council’s Revised Policy Statement on “Interagency Coordination of Formal Corrective Action by the Federal Bank Regulatory Agencies.”

The new statement outlines how a federal banking agency should proceed after deciding to take a formal enforcement action against any federally insured depository institution, depository institution holding company, non-bank affiliate or institution-affiliated party. According to the statement, each agency should first evaluate if the enforcement action relates to any areas that are regulated by other agencies. If it is determined that another agency has an interest in the enforcement action, then the agency proposing to take the action should notify the relevant agency (i) before notifying the party to the action or (ii) when the appropriate official determines that a formal action is expected to be taken. An agency should also share information with the other agency that will enable it to investigate the party.

Additionally, two or more agencies that plan to bring a complementary action are expected to coordinate on the preparation, processing, presentation, potential penalties, service and follow-up of the enforcement action.

FRB Proposes Changes to Volcker Rule

The Board of Governors of the Federal Reserve System (“FRB”) issued a proposal aimed at simplifying and tailoring compliance with the Volcker Rule. It is the first major overhaul of the Volcker Rule since regulations were adopted in late 2013.

The proposal, which remains subject to public comment, was developed in coordination with the Office of the Comptroller of the Currency, the FDIC, the SEC and the CFTC. In a statement, FRB Vice Chair for Supervision Randal K. Quarles called the proposal a “best first effort at simplifying and tailoring the Volcker rule,” noting that it does not represent the “completion of [the FRB’s] work.”

A detailed analysis of the proposal will be available shortly.

NY Fed President Calls for “Aggressive Action” for LIBOR Transition

Federal Reserve Bank of New York President William C. Dudley argued that “aggressive action” is needed across the financial industry to address market-wide issues concerning the global market transition away from LIBOR.

In his remarks at Bank of England’s Markets Forum, Mr. Dudley expressed concern over “the great uncertainty over LIBOR’s future and the risks to financial stability that would likely accompany a disorderly transition to alternative reference rates.” He stated, “we need aggressive action to move to a more durable and resilient benchmark regime.”

Mr. Dudley recounted the history and other factors that led to the need for the global markets to transition away from LIBOR. He emphasized that this transition represents a significant risk for firms “of all sizes,” which should actively manage the risks in a way that is commensurate with their exposures.

Mr. Dudley emphasized the important role of the official sector, including the Federal Reserve and the Financial Stability Board, in the development of reference rate principles, convening private sector participation and supplying robust alternative reference rates. He recognized the progress made by market participants acting through the Alternative Reference Rates Committee to identify a more robust U.S. dollar reference rate and to develop a plan for an orderly transition, including best practices in contract design. Mr. Dudley opined that “LIBOR is likely to go away – and it should,” but noted that there are those with a direct interest in LIBOR, “such as its administrator,” who support the “status quo.”

OCC Highlights Key Banking Risks

In its Semiannual Risk Perspective for Spring 2018 (the “Report”), the Office of the Comptroller of the Currency reiterated several key risks facing the federal banking system and expressed concern over the impact of rising interest rates.

In the Report, the OCC described improved financial performance of banks year over year and “incremental improvement in banks’ overall risk management practices.” The OCC noted that risks have not changed greatly since its previous report from Fall 2017. As stated, those risks are associated with:

  • incremental easing in commercial credit underwriting practices;
  • bank risk management of cybersecurity threats;
  • third-party concentration risk for certain products and services;
  • complex money-laundering and terrorism-financing methods that pose challenges in complying with the Bank Secrecy Act; and
  • weaknesses in compliance programs for consumer protection.

In the Report, the OCC added to its list certain risks associated with the “potential effects of rising interest rates, increasing competition for retail and commercial deposits, and post-crisis liquidity regulations for banks with total assets of $250 billion or more, on the mix and cost of deposits.”

In addition, concerns over integrated mortgage disclosure contained in the previous report were downgraded from comprising a key risk to an issue that should be monitored.

The OCC also stated that it is monitoring emerging risks including those associated with:

  • concentrations of commercial real estate;
  • low or declining prices for grain, livestock, and dairy that result in lower cash flow and increased farm carryover debt for agricultural borrowers; and
  • challenges to compliance management systems as banks address changes to consumer compliance requirements.

The Report is based on data collected as of March 31, 2018.

House Passes Bill to Ease Banking Regulations

By a vote of 258-159, the House of Representatives passed the “Economic Growth, Regulatory Relief, and Consumer Protection Act.” The bill would make changes to banking regulations implemented following the financial crisis of 2008. In March, the Senate voted 67 to 31 in favor of the bill. The legislation, which awaits President Trump’s signature, is the first major rollback of the Dodd-Frank Act.

The legislation provides relief to roughly two dozen regional banks and other institutions. It raises the threshold for enhanced prudential standards under Section 165 of Dodd-Frank from $50 billion to $250 billion. Currently, bank holding companies with total consolidated assets of $50 billion or more are subject to requirements addressing capital, liquidity management, resolution planning, credit exposure and other areas. In addition, the legislation raises the trigger point for having a risk committee and conducting company-run stress testing from $10 billion to $50 billion and $250 billion, respectively.

Relief for smaller banking organizations is a significant focus of the legislation. It provides capital-related relief for “qualifying community banks” that have less than $10 billion in assets and also meet a new leverage ratio to be designed by the federal banking regulators. The legislation also provides a limited exemption from the Volcker Rule for insured depository institutions that have less than $10 billion in assets and little or no trading book activity.

In addition, the legislation makes changes in a miscellaneous set of areas. It modifies the capital treatment of certain real estate loans by introducing a new, more limited concept known as an HVCRE ADC loan. It also requires the CFPB to promulgate ability-to-repay rules applicable to Property Assessed Clean Energy (PACE) transactions. Further, the legislation offers relief relating to certain mortgage products, including those relating to veterans as well as private student loans.
President Trump is expected to sign the legislation.

FRB Vice Chair Urges Reconsideration of Capital and Liquidity Requirements for Foreign Banks Operating in U.S.

Board of Governors of the Federal Reserve System Vice Chair for Supervision Randal K. Quarles encouraged regulators to reconsider the capital and liquidity requirements for foreign banks operating in the United States. He also proposed a return to the pre-financial crisis regulatory goal of maximizing the flow of capital worldwide.

In an address at Harvard Law School, Mr. Quarles stated that the current U.S. approach to foreign banks, which prioritizes increasing the resiliency of their U.S. operations, should be reconsidered. He argued that the events of the last financial crisis, when foreign banks recovered through the combined efforts of the United States and their home country governments, created the current U.S. approach, which prioritizes ensuring that the United States has sufficient resources to address another such event. He stated that while most regulators seem to believe that intermediate holding company (“IHC”) and attendant requirements are appropriate, the regulation of the IHC could be modified without harming financial stability. He suggested that if the United States recalibrated its requirements, other jurisdictions would, too. This outcome, he argued, would increase the flow of capital, which should be the goal of regulators.