The big reason banks despise the Fed’s capital rule

From: POLITICO's Morning Money - Wednesday Jan 17,2024 01:01 pm

Jan 17, 2024

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QUICK FIX

Bankers really hate the latest proposal to substantially raise their capital requirements. You probably know this — after all, they’ve launched an all-out defensive campaign complete with a dedicated website against the plan by the Federal Reserve and other regulators. But the thing they detest the most about the “Basel III endgame” is — even by financial regulatory standards — pretty esoteric and therefore hard to talk about. It’s related to “operational risk,” and if that sounds vague and broad, it is.

It’s also the central battleground in the Basel fight, with Fed Governor Christopher Waller arguing that there needs to be massive revisions to that section to get his support.

Your MM host enjoys referring to op risk as “the risk that someone will do something stupid or illegal,” although the term also covers factors outside a firm’s control, like a natural disaster. Basically, banks are being asked to have a bigger cushion of money to cover costly disruptions to doing business. To date, the most expensive operational risk losses incurred by big U.S. banks have been related to litigation — in particular, the lawsuits for their actions in the leadup to the 2008 financial crisis. But they might face any number of future issues, like a catastrophic cybersecurity attack.

This brings us back to capital. Capital is, by definition, intended to cover unexpected losses (banks have a whole separate way of preparing for expected losses). But the problem with unexpected losses is that they’re, well, unexpected. And that makes them hard to measure.

Regulators, using internationally negotiated standards as a guide, have decided the best way to set the requirements is based on two factors: revenue and historical losses. Revenue acts as a proxy for the size of a business line and the risks it might pose, without penalizing things like lending that take up a lot of balance sheet space. Banks are dinged if they’ve had higher losses over the past 10 years, but they don’t get credit if they have particularly low losses. Both measures feed into a relatively simple capital charge to absorb future operational losses.

The upshot is that the proposal will really hit fee-based businesses like asset management, wealth management, and advisory services, which don’t face the big capital charges that credit-sensitive business lines do.

It’s a pretty big shift from the status quo, where banks are allowed to come up with their own op risk models based on historical data, future risks they foresee, as well as specific problems they’d like to guard against. (Under the new regime, the Fed’s annual stress tests would be the only forward-looking operational risk capital requirement, though banks argue that having both is unnecessarily duplicative.) Indeed, reducing banks’ ability to game their own capital requirements is the point.

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The industry says the proposal is total overkill and needs to be both recalibrated and reduced. They, and Waller, also say that operational losses aren’t usually correlated with, say, credit risk events, so there’s not really a need to have another capital buffer for it.

“The charge for operational risk is extraordinary,” Bank Policy Institute CEO Greg Baer told reporters Tuesday. “It's almost double the worst year of operational losses in history … and it assumes counterfactually and counterintuitively that op risk losses are perfectly correlated with market risk and credit risk losses, and therefore that you need to cover the worst case of all three simultaneously and capitalize for it.”

Karen Petrou, managing partner of Federal Financial Analytics, argues that banks’ money is better spent in other ways.

“What matters in terms of op risk in a cyber attack or a natural diaster, it’s not how much capital you have,” she told MM. “It’s whether or not you have redundant systems, backups, and appropriate controls. The amount of money you have stashed away in this punitive capital account will come in handy down the road for building new systems or paying litigation fines or handling angry customers. But the money would’ve been far better spent building resilient systems.”

Regulators’ response to these kinds of complaints about Basel is always the same: We’re listening.

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Driving the day

Fed Vice Chair for Supervision Michael Barr speaks on cyber risk at 9 a.m. … U.S. Chamber of Commerce holds a conference starting at 8 a.m. featuring Fed Governor Michelle Bowman and Reps. Andy Barr (R-Ky.) and Bill Foster (D-Ill.) … Public Citizen hosts an event starting at 1 p.m. featuring SEC Chair Gary Gensler and Rep. Maxine Waters (D-Calif.) … the Joint Economic Committee holds a hearing on affordable housing supply at 2:30 p.m. … FinRegLab hosts a webinar with regulatory officials to discuss the use of artificial intelligence in financial services at 2:30 p.m.

Just in: CFPB cracks down on overdraft fees — Our Katy O’Donnell reports: “The CFPB on Wednesday released a long-awaited proposal to rein in the overdraft fees banks charge when a customer’s account has insufficient funds to cover a transaction. The rule is part of a broader Biden administration campaign to crack down on so-called junk fees – a priority President Joe Biden touted in his State of the Union address last year.

… The proposal would allow banks to charge fees to cover the cost and losses associated with providing the service for courtesy overdrafts — either a ‘breakeven’ fee based on the bank’s own calculation or a benchmark fee. The CFPB proposed several options for the benchmark fee, ranging from $3 to $14.”

Citi chair banks on Basel compromise — Citigroup Chair John Dugan is optimistic that regulators will scale back the planned hike in bank capital requirements and potentially head off an industry lawsuit to block the rules.

Dugan told Zach Warmbrodt on the sidelines of the World Economic Forum in Davos that he’s “more optimistic than many of my colleagues that there will be some kind of compromise that comes out of this that has a broader consensus among the bank regulators.”

“There’s a tremendous feeling when you’re in a regulatory agency that you help preserve the independence of your agencies by coming out with consensus rules,” Dugan, a former Comptroller of the Currency, said. “A very closely divided thing is just less likely. Right now, what it feels like to me, the only way to get to a consensus is to move the rule to a much more pragmatic and less overreaching place than where it was before.”

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Rate cuts? Not yet — Back to Chris Waller, he said on Tuesday that while he sees the case for cutting borrowing costs in 2024, right now he thinks that policy is “set properly” and that when the time comes for rate cuts, they should be done “methodically and carefully.”

“In many previous cycles, which began after shocks to the economy either threatened or caused a recession, the FOMC cut rates reactively and did so quickly and often by large amounts,” he said at a Brookings Institution event. “This cycle, however, with economic activity and labor markets in good shape and inflation coming down gradually to 2 percent, I see no reason to move as quickly or cut as rapidly as in the past.”

HFSC eyes nuclear energy — The House Financial Services Committee is making its first foray of the session into nuclear energy with a subcommittee hearing this afternoon, Eleanor reports. Republicans' goal? To “emphasize the importance of nuclear energy financing to counter Chinese and Russian ambitions,” per an internal memo shared with Eleanor, as well as “discern the significant political and institutional support needed to expand nuclear financing.”

The committee has noticed a bill from Chair Patrick McHenry that would direct the Treasury secretary to "work to overturn" a World Bank prohibition on nuclear assistance, in the words of another internal memo. DoE, FERC and NRC officials will appear on the Hill later this week to testify before House Oversight Committee members on related issues.

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Davos Dispatch

Zelenskyy x Wall Street — Ukrainian President Volodymyr Zelenskyy met Tuesday with top executives and investors to talk through post-war infrastructure and rebuilding. A meeting organized by JPMorgan included JPMorgan's Jamie Dimon and Mary Erdoes, Michael Dell, Stephen Schwarzman and Ray Dalio. Bank of America CEO Brian Moynihan also met with Zelenskyy.

BlackRock Vice Chair Philipp Hildebrand told reporters after meeting with Zelenskyy that the goal is to find a way to "de-risk" potential investments in Ukraine by having countries fund a "catalytic capital tranche" that would then be followed by private sector capital. He said Ukraine's priorities include digitalization, manufacturing, infrastructure and agriculture.

Dimon and Moynihan were also expected to attend a dinner Tuesday with Secretary of State Antony Blinken and U.S. Special Representative for Ukraine's Economic Recovery Penny Pritzker.

Scaramucci versus Davos — Anthony Scaramucci told Zach that the Davos crowd consensus, including many CEOs and diplomats, is that President Donald Trump will win the 2024 election. The good news for Scaramucci, an outspoken Trump critic following a brief stint in his White House, is that he says the Davos conventional wisdom had it wrong in 2016 and 2020.

If it comes down to Trump versus Biden as expected, the SkyBridge Capital founder said business leaders should back the sitting president. Biden’s too old to be commander in chief in Scaramucci’s view, but “he’s got a great staff, and they’ve done a good job,” he said over scrambled eggs at his reserved table at the Davos Hilton Garden Inn.

With regard to Trump, Scaramucci said business leaders are failing to study political history.

“The business leaders were generally okay with Mussolini. They were generally okay with Hitler. Until it goes crazy,” he said. “Then five years into it the cronyism kicks in, the unpredictability of the law kicks in, the expansion of autocratic powers kicks in. ... [Trump] has told you he wants to be a dictator. He has told you that he wants to expand the executive powers. He has told you he’s going to go after his enemies.”

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With offices in Washington, DC, New York, Brussels, and London, MFA is the leading voice on public policy issues affecting the alternative asset management industry. Visit MFAalts.org to learn how MFA helps its members get connected, stay informed, and shape the future of alternative asset management.