Our Take: financial services regulatory update – May 31, 2024

• What happened? On May 20th, Fed Vice Chair for Supervision Michael Barr spoke on the importance of building a resilient regulatory framework especially in light of last March’s bank failures. Separately, on May 27th, Acting Comptroller of the Currency Michael Hsu discussed the importance of recovery planning.
• What did Barr say? He highlighted the Fed’s work on three components that underlie the resilience of the banking system and discussed several modifications that have been proposed or are being considered:
  • Capital. Barr reiterated previous remarks that the banking agencies are actively working through comments on the Basel III endgame proposal and are looking at “broad and material changes.” With regard to the bank failures, he specifically highlighted the proposal’s extension of the requirement to reflect the impact of unrealized losses on capital through accumulated other comprehensive income (AOCI) to all banks with over $100 billion in assets.
  • Liquidity. He discussed several potential changes to improve banks’ liquidity resiliency. He noted that the Fed is considering requiring banks to “maintain a minimum amount of readily available liquidity with a pool of reserves and pre-positioned collateral at the discount window, based on a fraction of their uninsured deposits.” Barr explained that such a requirement would address two key issues at the center of the bank failures - heavy reliance on uninsured deposits, a run on those deposits, and a lack of readiness - or willingness - to use the discount window. With regard to the latter, he noted that this requirement would emphasize supervisors’ expectations for banks to use the discount window and that the Fed is also considering modifications to improve its functionality.
    He also previewed a potential restriction on the extent of reliance on held to maturity (HTM) assets under large banks' liquidity coverage ratios (LCRs) and internal stress tests. Finally, he said the Fed is reviewing banks’ calibration of deposit outflow assumptions for certain types of deposits, such as those of high-net-worth individuals and companies associated with venture capital or digital assets.
    
  • Resolution and long-term debt requirements. Barr also discussed the Fed’s August 2023 proposal to extend long-term debt to more large banks and how it would complement the capital and liquidity requirements he covered. He noted that “many commenters” were supportive of long-term debt requirements while suggesting several modifications that the Fed is considering.
• What did Hsu say? He discussed the importance of enhancing recovery planning at large banks in order to prevent broader disruption in the event of stress. Most notably, he expressed his belief that recovery planning guidelines should be expanded from the current $250 billion threshold to all banks with over $100 billion in assets. This threshold was increased to $250 billion from $50 billion in 2018 in line with that year’s regulatory relief law. He also described three elements of the OCC’s Guidelines Establishing Standards for Recovery Planning:
  • Triggers. Hsu highlighted that triggers can be quantitative or qualitative. Quantitative triggers may be related to a bank’s liquidity and capital levels or to its stock price or CDS spread. Qualitative triggers might include credit rating downgrades, severe financial stress at major counterparties, or significant operational risk events.
  • Options. He explained that recovery options can range from sales of portfolios or lines of business to securing of long-term funding to capital preservation measures and emphasized that banks need to have actionable options that they have fully worked through to make sure they can be acted on during stress.
  • Impact assessment. Hsu noted the importance of managers and boards of directors undertaking impact assessments to understand the full range of consequences of taking certain actions.

Our Take

Barr devoted little attention to Basel III endgame. Despite the significant uncertainty swirling around the future of the controversial Basel III endgame proposal, Barr spent little time on the topic aside from holding the party line promising “broad and material changes.” Within the proposal, he focused primarily on the requirement for more banks to recognize unrecognized losses on securities in their capital requirement calculations. With much of the proposal prompting industry criticism and debate within the agencies, this focus on AOCI indicates that it is not one of the provisions that is likely to significantly change. Similarly, Barr’s comments on the long-term debt proposal receiving positive feedback indicates that it has a relatively straightforward path to finalization, albeit with modifications. Overall, the inclusion of these two topics in Barr’s speech reflects the agencies’ focus on regulatory changes that are more directly related to last year’s bank failures while continuing to study and debate the extensive comments on other aspects of Basel III endgame.

Liquidity proposal on the horizon? Barr provided the greatest level of detail to date on the Fed’s consideration of changes to liquidity requirements. However, there are many unanswered questions raised by the potential requirements he describes. For example, Barr does not specify the applicability threshold. It could be $100 billion in assets in line with the Basel III endgame and long-term debt proposals, but there could also be discussion of less stringent standards for “midsized” banks under $100 billion in assets like Hsu had previously floated. The industry will also be awaiting further detail on how the requirements would account for different balance sheets and business models, such as those that have high amounts of uninsured deposits like large commercial and custody banks. The impact of these requirements would vary based on these factors, but they would affect many banks’ funding models and the profitability of their commercial activities if they are required to hold more liquid collateral as a backstop for larger amounts of assumed deposit outflow risk. This increased liquidity requirement alongside restrictions on HTM securities and the change to AOCI through Basel III endgame would collectively complicate banks’ investment decisions. Finally, it is unclear when the Fed (with or without other agencies) will be able to propose and finalize new liquidity requirements with numerous competing agenda items, including Basel III endgame, and the looming election.

Recovery planning expansion may be further from the proposal stage. As Hsu closed his speech with the suggestion that expanding recovery planning guidance “warrants serious consideration,” it appears that this idea is still in the discussion stage rather than ready for an imminent proposal. His speech makes the case that banks of a similar size to those that failed last year should be more thoroughly prepared for stress to reduce the need for extraordinary support from the regulatory authorities, but many of the goals of a recovery plan Hsu describes should already be covered in banks’ contingency funding plans. Hsu’s suggested expansion would only partially reverse the 2018 regulatory relief but would still recapture a number of institutions that would need to refresh past plans to account for numerous changes to their businesses and market dynamics in the last six years.