Our Take: The changing regulatory landscape

On December 1st, Fed Vice Chair for Supervision Michael Barr gave a speech on bank capital standards. He explained that the Fed’s review of capital standards is still ongoing, including its consideration of the final set of Basel III or “Basel endgame” requirements and adjustments to the supplementary leverage ratio (SLR). While he did not announce any definitive upcoming actions, he stated several times that the Fed’s response to changing risks, such as the growth of nonbank intermediation, should not be to reduce capital requirements.

Barr further indicated that he is approaching the review of capital standards in the context of research on the level of capital that optimizes benefits and costs. He also responded to banks’ assertions that their resilience through the pandemic “suggests that bank capital is already high enough” by saying that it was not a real test due to significant government assistance to the economy. He outlined a number of other unpredictable events over the last year and said the Fed is “evaluating whether the supervisory stress test that is used to set capital requirements for large banks reflects an appropriately wide range of risks.” Barr further discussed the potential for stress testing to evolve to assess contagion and interconnectedness.

Our Take

Although Barr did not announce any concrete timing or policy changes, this speech provided a clear insight into the direction he intends to take. At several points in the speech, he effectively ruled out any adjustments that would reduce capital requirements. Banks will also likely be concerned about his preemption of their argument that they served as a source of strength through the pandemic. However, his acknowledgement of the necessity of balancing benefits and costs of higher capital suggests that the Fed will carefully consider the potential impacts of any upcoming proposals. As Basel endgame implementation plans and potential modifications to the SLR have been underway since well before Barr’s nomination, it remains likely that we will start to see proposals in Q1 next year. In addition, the expected release of stress testing scenarios in February or March will provide an opportunity for Barr to influence capital requirements well before any new policies are finalized. While it may not come as a shock given the change in Fed leadership, banks should be prepared to face tougher stress tests including new types of shocks and possibly increased capital requirements over the next several years.

This week, the following notable events took place regarding digital assets:

• The Senate Agriculture Committee held a hearing around several pieces of digital asset legislation, with recent collapses of major exchanges a key area of focus in the discussion. CFTC Chair Rostin Behnam testified that the Commission does not have authority to oversee digital asset markets for the type of activity that contributed to the recent failures and urged Congress to pass legislation providing such authority. He explained that he supports legislation that would give the CFTC authority over “the more limited subset of commodity tokens” while giving the SEC authority over security tokens - noting that he would work with SEC Chair Gary Gensler to determine which assets are securities and which are commodities. Several Senators discussed whether current legislation before the Committee could have prevented these failures and whether support from leadership of certain now-bankrupt exchanges indicates that it is insufficiently strong. In response, Behnam stated that he does not believe such exchanges would have met the legislation’s requirements.
• Treasury’s Office of Foreign Assets Control (OFAC) announced that it reached a settlement agreement with a large digital asset exchange for providing services to Iranian customers in violation of sanctions restrictions. The announcement notes that the exchange’s failure to implement appropriate geolocation tools, including an automated IP address blocking system, contributed to these violations. The accompanying enforcement notice highlights that due to several mitigating factors, including that the exchange self-disclosed the violations and enhanced its sanctions compliance program by adding geolocation blocking and blockchain analysis tools, investing in training for staff, and hiring a head of sanctions compliance, OFAC assessed a penalty of only approximately $360,000.
• The New York Department of Financial Services (NYDFS) released a proposal to collect supervisory costs from digital asset firms that have a BitLicense from the agency, which allows them to conduct business in New York State. The announcement acknowledges that the NYDFS collects such fees from regulated banks and insurers.

Our Take

The recent collapses of several digital asset firms have brought alarm bells up to a blare regarding the need for regulatory scrutiny and investor protections in the digital assets space. In this week’s Senate hearing, both sides of the aisle showed support for stronger and clearer rules, with ideas such as capital and liquidity requirements, prohibitions on mixing customer funds with investment functions, and scrutiny of business models that combine multiple functions (e.g., clearing, trading, custody) all on the table. However, clear divisions in approach became evident, with some Senators calling for the passage of the current legislation as-is and allowing the CFTC to pursue these protections through its rulemaking authority, while others supported a rewrite of the bill to explicitly add new protections. The discussion also left the age-old question of CFTC vs SEC jurisdiction open, but notably Chair Behnam described commodity tokens as “the more limited subset” compared with security tokens - a change in tone from previous remarks that most assets would fall under his agency’s jurisdiction. Going forward, having clear definitions around whether digital assets are securities or commodities will be essential so firms know where to register and both industry and regulators know how to apply the rules. Beyond the discussion in this week’s hearing, we expect that regulators will grapple with the fact that many digital asset firms are a network of entities affiliated through common ownership, located across multiple jurisdictions. As such, discussions will likely include the potential for comprehensive consolidated supervision - potentially with holding company requirements similar to the banking industry - in order to provide authorities with the view adequate to detect the kind of misconduct that led to recent failures and to safely resolve or wind down parts without jeopardizing the whole.

While the debate around regulatory jurisdiction continues, one area of regulatory reach is abundantly clear: OFAC and FinCEN are closely monitoring the digital assets industry for financial crime such as sanctions and money laundering. This week’s enforcement action from OFAC may seem minor due to the small penalty, but it is a reminder that by self-disclosing accidental violations, investing in appropriate controls such as geolocation tools, and taking governance of sanctions compliance programs seriously, firms may be shown leniency from the traditionally high fines that come with running afoul of sanctions rules.

These notable developments hit our radar this week:

• Fed proposes climate risk management principles. On December 2nd, the Fed issued a request for comment on a set of principles for climate-related risk management for large financial institutions. While the Fed’s proposal features some differences in phrasing, the principles are substantially similar to those proposed by the OCC last December and FDIC in March. All three proposals are targeted to banks with over $100b in total consolidated assets and cover expectations across climate-related governance; policies, procedures and limits; strategic planning; risk management; data, risk measurement and reporting; and scenario analysis. They include an expectation that the board and management understand the evolution of climate-related risk and their institution’s exposures to those risks over time horizons that “extend beyond the bank’s typical strategic planning horizon.” The Fed will accept comments for 60 days and will join the other agencies in issuing a final joint version of the principles. For more, see Our Take on the FDIC proposal.
• Senate Banking holds FDIC confirmation hearing. On November 30th, the Senate Banking Committee held a hearing on the nomination of Acting Chair Martin Gruenberg to serve as the agency’s confirmed Chair. In his prepared testimony, Gruenberg highlighted supervisory priorities regarding risks to banks from inflation, rising interest rates and geopolitical uncertainty. He also highlighted policy priorities of finalizing Community Reinvestment Act reform “in the early part of next year” as well as addressing areas including climate change risk, bank mergers, digital assets, and finalizing Basel III capital rules. Republican Senators focused their questions on pushing back against potential ESG expectations, including questioning whether Gruenberg would restrict lending to certain industries.
• SEC releases 2022-2026 strategic plan. On November 29th, the SEC released its strategic plan for the years 2022-2026. The plan includes goals of continuing to improve its use of data analytics to detect and enforce against improper behavior, modernizing disclosure requirements, evolving to meet demands from new technologies, and focusing on diversity and inclusion initiatives within the agency.
• OCC updates civil money penalty manual. On November 29th, the OCC announced updates to the civil money penalty manual that it uses to calibrate enforcement actions. The updates further differentiate by levels of misconduct and institution size along with modifying the mitigating factors - including self identification, remediation and restitution - “to provide a stronger incentive for banks to fully address underlying deficiencies.” The OCC will begin using the updated manual on January 1, 2023.