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Current topics - July 12, 2019

Fed talks stress testing

On Tuesday, the Fed hosted a conference on stress testing which featured remarks by Chair Jerome Powell and Vice Chair for Supervision Randal Quarles. Powell also answered several questions on stress testing before the House Financial Services Committee and Senate Banking Committee while Quarles spoke at the Bipartisan Policy Center yesterday. Their remarks touched on the following topics:

  • New SCB proposal to come out in the “near future.” Both Quarles and Powell indicated that they intend to have the stress capital buffer (SCB) in place for the 2020 capital planning cycle. The SCB would add institution-specific stress buffers based on the most severe shock from the comprehensive capital analysis and review (CCAR) process to banks’ ongoing capital requirements. It attracted considerable industry commentary after it was proposed last April, and Quarles explained that the Fed would release a revised proposal in the “near future” to address some of those comments. For example, Quarles noted yesterday that he intends to address industry calls to remove the stress leverage buffer so that leverage is a backstop rather than a primary constraint.
  • GSIB surcharge will be in the SCB but the level of buffers could be up for review. Quarles noted that he believes that the global systemically important bank (GSIB) surcharge - i.e., extra capital that the Fed requires these institutions hold - conceptually belongs in firms’ post-stress capital minimums along with the SCB. However, he explained that the Fed may be willing to reassess the calibration of the surcharge.
  • Addressing volatility. Concerned about how the volatility in stress testing results creates difficulties in banks’ capital planning processes, Quarles floated two ideas: 1) averaging stress testing results over two or more cycles and 2) providing firms with the Fed’s quantitative results prior to submitting their plans (which would be accomplished via the SCB).
  • Fed and industry continue to focus on transparency. No topic was discussed more frequently or more in depth than transparency. Quarles recounted the centrality of transparency to the effectiveness of the stress testing program, explained how transparency has increased over the years and reiterated plans to further increase transparency into models, at the rate of two models per year going forward.
  • Countercyclical capital buffer (CCyB). On Thursday, Quarles noted that the Fed is currently reviewing the CCyB framework. The CCyB has been set at zero since its inception, and Quarles said it has essentially become redundant but that it may be worth considering in order to have a mechanism to increase or decrease capital requirements as market conditions change.

Our take

It is now abundantly clear that the SCB is coming - changes will be made, but the Fed is clearly committed to taking this approach. The SCB would fully integrate stress testing into the ongoing bank holding company capital regime, but perhaps most importantly, banks would be able to plan distributions with full knowledge of their capital requirements as opposed to trying to guess the supervisory stress impact. One important impact will be the elimination of the “mulligan” - i.e., reducing planned distributions to avoid capital requirement breaches - that banks sometimes take within days when results are published in June. However, this also means that the banks and the Fed will need to focus more on baseline projections in order to avoid situations where banks need to regularly make quarterly downward adjustments to meet ongoing capital requirements (in essence, a travelling mulligan).

Although the Tuesday conference was primarily about stress testing, Quarles made news by indicating the possibility of recalibrating the GSIB surcharge. Regulators have previously held firm that the capital levels at the biggest banks are at the right level, so any suggestion that they are considering recalibrating capital requirements is significant. Changes to the biggest banks’ capital requirements could have a substantial impact on their returns and payouts.

Quarles’ suggestions for decreasing volatility in annual stress test outcomes by averaging the Fed’s quantitative results over multiple cycles would also be significant, but before reducing the sensitivity of the exercise, we expect the Fed to think through a number of potential issues before formally proposing this change. For example, changes in risk, portfolio characteristics or market conditions - positive or negative - would create a lag in the amount of capital firms would be required to hold.

If the Fed were to decide to use the CCyB it would have to simultaneously revisit the scenario design framework, which already has built-in counter cyclicality. Using the CCyB would also require the Fed to be more transparent on its views on the market, which it may be reluctant to do. Banks may also be concerned that the Fed would be slow to remove any additional buffers once they are put in place. For these reasons, the CCyB has long been controversial and we believe utilizing the CCyB is unlikely to happen anytime soon.

For information on the Fed’s recent stress test results, see our First take.

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SEC and FINRA keep crypto door open

On Monday, the SEC and FINRA released a joint statement to remind crypto industry participants that it has not forgotten about pending broker-dealer license applications, some of which have been in limbo for over a year, but the issues being discussed are novel and quite complex in nature. The statement explains that the main hurdle is around the Customer Protection Rule, which requires that broker-dealers safeguard client assets lien free at a good control location. This presents several complications in the digital securities universe, including concerns around the security of the “private key” system - i.e., an alphanumeric password used to access digital assets - as well as other cybersecurity and fraud threats.

While broker-dealer approvals have been delayed, the SEC made a monumental move yesterday by allowing, for the first time (and second only a day later), the Regulation A+ funding of a firm where instead of shares investors will receive tokens.

Our take

With this week’s statement, the SEC and FINRA are reminding an industry that has been left waiting that they are focused on getting it right. As tremendous growth and development has occurred within the industry this past year in establishing the necessary infrastructure for digital assets, the securities regulators appear to be following recent steps from other regulatory bodies such as FinCEN and the Financial Action Task Force in warming to the crypto space. They have been listening, engaging with participants and are now beginning to move forward to reduce uncertainty. However, while some issues (e.g., fundraising) can be resolved more easily, others such as custody will require more careful thought. While the SEC has made it clear that it will work with participants to fundraise in more innovative ways, two token based Reg A+ raises in two days, it will do so in a targeted fashion for those firms working within the prescribed regulatory framework.

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Treasury broadens sanctions reporting

Last month, Treasury’s Office of Foreign Assets Control (OFAC) issued an interim final rule that broadens sanctions reporting requirements and increases related penalties. Notably, the rule expands reporting requirements related to transactions that were rejected due to sanctions compliance issues from US financial institutions to all US persons or entities. Previously, non-financial institutions were only required to report “blocked” transactions (i.e., those put into frozen accounts due to a direct connection with persons on OFAC’s Specially Designated Nationals list). The rule also clarifies that reportable transactions are not limited to funds transfers but also include wire transfers, trade finance, securities, checks, foreign exchange, and goods or services. Other sections of the rule raise the maximum prison term for criminal sanctions violations from 10 to 20 years and provide details around information that must be reported.

Our take

While this seemingly technical update was not exactly dinner table discussion or headline news, it is nevertheless a big deal that is leaving compliance teams at US companies scrambling. The rule does not provide details around under which circumstances companies would be required to report rejected transactions, but taken at face value they would have to report them all - including, for example, inquiries related to sanctioned countries by foreign subsidiaries of US firms. Going forward, we expect companies to seek clarity from OFAC and request that they narrow the rule’s scope, as many will have to significantly enhance their staff and risk management framework to comply. We also expect to see a significant increase in reporting-related violations due to the rule’s expanded scope. In many instances, these violations will be picked up through banks' reporting of rejected transactions, where OFAC could look for corresponding reporting from underlying companies and begin investigating.

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LIBOR Transition: A blueprint for a SOFR ARM

Earlier this week, the Alternative Reference Rate Committee (ARRC) released guiding principles and scope for the work of its Consumer Products Working Group, a new consultation on fallback contract language for new adjustable rate mortgages (ARMs), as well as a white paper on options for using the Secured Overnight Financing Rate (SOFR) in adjustable rate mortgages. The white paper lays out a framework for developing a SOFR-indexed ARM and associated implications for consumers, originators, servicers and investors.

In addition, both Fannie Mae and Freddie Mac released statements in support of SOFR as the preferred replacement transitioning from USD LIBOR to SOFR for single-family ARMs, indicating that they would look to apply the ARRC’s published framework in the development of a new mortgage product. Ginnie Mae has yet to publish guidance, but is expected to align with the framework developed by the ARRC and supported by Fannie Mae and Freddie Mac.

Our take

Several mortgage companies have indicated that they need at least nine months of lead time to prepare systems, documentation, governance, customer education, and risk management requirements to make an orderly transition from LIBOR-indexed ARMs to SOFR-indexed ARMs. As such, mortgage industry participants will need to begin the transition to SOFR well in advance of LIBOR’s anticipated cessation. In addition, the complexity associated with developing an ARM product indexed to an overnight rate presents new challenges. For instance, agreement about how ARM accrual rates are calculated is still a work in progress. However, while these and other technical aspects of the new ARM product have yet to be agreed upon by industry participants, the white paper provides a path forward for industry participants to align around new product specifications. The proposal further cements the clear indications from the ARRC and US regulators that institutions should act now to develop solutions based on the overnight SOFR index and not wait for potential future developments. By providing a practical solution, endorsed by the two giants of the US mortgage sector, ARRC is also providing a lens into future market practice.

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On our radar

These notable developments hit our radar this week:

  • Volcker shrugged. On Thursday, Vice Chair Quarles said that the multi-agency (Fed, FDIC, OCC, SEC and CFTC) effort to reform the Volcker Rule would advance this fall. He said the agencies would likely finalize certain elements of last year’s proposal while re-proposing other elements. On Tuesday, the agencies adopted a final rule to exclude community banks with $10b or less in total assets and liabilities of five percent or less of total assets from the Volcker Rule.
  • Fed nominations. Last week, the Administration announced that it would nominate Christopher Waller and Judy Shelton to the Federal Reserve Board. Waller is the current research director at the St. Louis Fed and has advocated for Fed independence, a default insurance system, and greater flexibility with inflation targets. Shelton, the US executive director at the European Bank for Reconstruction and Development, holds more controversial views including calling for a return to the gold standard.
  • Fed warns of growing synthetic ID fraud threat. On Tuesday, the Fed released a report on synthetic ID fraud. The report cites studies showing that this type of fraud is the fastest growing type of financial crime in the US and explains how fraudsters create synthetic identities to commit theft and launder money. It also calls for greater collaboration among the industry, agencies and law enforcement to better understand, detect and prevent these threats.
  • SEC and CFTC propose cutting margin on futures. On Tuesday, the SEC and CFTC issued a joint proposal that would lower the minimum margin on securities futures from 20 to 15 percent. The agencies explain in the proposal that this cut would align the treatment of these futures with comparable financial products.

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Julien Courbe

Financial Services Advisory Leader, PwC US

Tel: +1 (646) 471 4771

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