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Our Take: financial services regulatory update - May 27, 2021

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Change remains a constant in financial services regulation. Read "our take" on the latest developments and what they mean.

Current topics - May 27, 2021

Senate Banking hears from Quarles, big bank CEOs

On Tuesday, Fed Vice Chair for Supervision Randal Quarles presented his semiannual testimony on the supervision and regulation of the financial system to the Senate Banking Committee. Areas covered by his testimony and subsequent questioning from Senators included:

  • The pandemic-related crisis and return to normal. He noted that the economy is beginning a strong recovery as the pandemic-related crisis recedes. He explained that while the banking sector remained resilient due to higher levels of capital and liquidity, there are lessons learned going forward, including:

    • Stress testing. Quarles explained that it was sensible to impose temporary restrictions on capital distributions given that this was the first post-2008 crisis test of the system. However, he expressed that the pandemic-related crisis revealed that “the system works” and going forward the Fed can “rely on the automatic restrictions of our carefully developed framework rather than impose ad hoc and roughly improvised limitations.”

    • Money market funds. Highlighting that the crisis saw the second time in a decade that money market funds (MMFs) experienced significant stress that required public intervention, Quarles explained that work is ongoing both domestically and at the Financial Stability Board to address these vulnerabilities.

  • Cryptocurrency. A bipartisan group of Senators including Senate Banking Chair Sherrod Brown (D-OH), Sen. Mark Warner (D-VA), and Sen. Cynthia Lummis (R-WY) asked about the Fed’s view regarding cryptocurrency regulation, with the Democrats urging that it apply stricter scrutiny. Quarles explained that the Fed is currently working with the OCC and FDIC on a cryptocurrency “sprint” to develop a unified approach to regulation.

  • Central bank digital currencies (CBDCs). Sen. Chris Van Hollen (D-MD) applauded Fed Chair Jerome Powell’s recent announcement that the Fed is researching the possibility of issuing a digital dollar, and he asked Quarles for more information as well as whether the Fed will require any action from Congress. Quarles explained that research is underway and the main question for now is whether issuing a US CBDC would be appropriate. He also noted that offering a US CBDC would most likely require some form of legislative authority.

  • Financial inclusion and bank mergers. Sen. Brown stated that 5,600 bank branches have closed within the US over the last decade, and 20% of which were the only bank branch within the census tract. He asked Quarles if the Fed’s approving of bank mergers is hastening this trend, to which Quarles responded that bank branch closures are carefully reviewed when making approval decisions.

  • Climate risk. A number of Democratic Senators expressed support for further action to address climate risk in the financial system, while several Republican Senators decried this focus as politically-motivated and distracting from “real” risks such as asset bubbles and inflation.

  • Community Reinvestment Act (CRA). Sen. Bob Menendez (D-NJ) and Sen. Raphael Warnock (D-GA) applauded the OCC’s recent announcement that it will delay the implementation of its CRA reform rule and explained that they would like to see a joint OCC, Fed and FDIC rule emerge. Quarles replied that the Fed’s objective is to see a joint rule and that it is engaging with the OCC with the intent to get on the same page.

  • Fair lending. Sen. Brown called upon Quarles to take more aggressive action to address racial inequities through enforcement of fair lending policies. Quarles defended the Fed’s actions by stating that it has been taking such action.

  • Other priority areas. Quarles explained that significant near-term priorities include the finalization of Basel III reforms and completing the LIBOR transition, noting that he expects the Fed to release a proposal for finalizing Basel III later this year. He also highlighted cybersecurity, operational resilience, and artificial intelligence (AI) as other areas the Fed is working to address.

  • Archegos and other market volatility events. Several Democratic Senators urged the Fed to take stronger action in response to the Archegos incident and other incidents that created market volatility, including reversing recent actions that released some foreign banks from higher levels of scrutiny.

One day after Quarles’ hearing, the Senate Banking Committee heard testimony from the CEOs of the six biggest US banks. In their testimonies, the CEOs generally highlighted their banks’ handling of issues related to the pandemic, lending to disadvantaged communities, expansion of diversity and inclusion (D&I) initiatives and development of environmental, social and governance (ESG) policies. Some testimonies also included statements around taking a risk-based approach to deciding whether to use or support technologies such as artificial intelligence (AI), digital ledger technology and cryptocurrencies.

Democrats generally urged the CEOs to do more regarding supporting vulnerable communities, D&I and ESG. Some Democrats, such as Sen. Elizabeth Warren (D-MA), brought up consumer protection issues such as banks’ charging overdraft fees. In contrast, many Republican Senators urged the banks to avoid making decisions based on “politically-motivated” issues such as gun manufacturing, public statements on voting laws, and climate change, which they explained could result in misallocation of finances. There was some bipartisan agreement, however, as Sens. Mark Warner (D-VA) and Bill Hagerty (R-TN) both expressed their support for addressing risks related to both cybersecurity and cryptocurrency. 

Our Take

The big bank CEOs, perhaps recognizing the new Administration’s focus on ESG and public attention to social issues, came prepared to show that they are for the first time leading the way on issues such as climate change, D&I, and even taking a stand on voting rights. While Republican Senators attacked both the banks and regulators for focusing on “politically-motivated” issues, the bank CEOs defended taking political stances as promoting responsible investments that address issues material to their shareholders. With this push from the banks on social issues and the Democrats’ control of the White House and Congress, the direction ahead appears to be a continued focus from both the private and public sector on ESG issues. Expect the Democrats to continue holding banks accountable on these issues, including calling out a lack of progress on D&I initiatives and pushing for stronger consumer protections. While we could see Sen. Warren continue her push for additional guardrails on overdraft fees, it remains to be seen whether the regulators will follow suit.

Meanwhile, Quarles’ acknowledgment that the agencies are currently working together on issues such as cryptocurrency regulation and CRA reform could mean that the joint regulatory approach that OCC Acting Comptroller Michael Hsu called for in his testimony last week could produce results sooner than expected. For cryptocurrency, the agencies will likely release some form of discussion paper or proposal focusing on outstanding issues such as capital treatment. With regard to CRA reform, we expect to eventually see a unified rule with the OCC moving closer to the Fed’s proposal. Momentum is also building for cybersecurity, which is another area that could see movement in the near future considering President Biden’s recent Executive Order, bipartisan Congressional support, the banking agencies recently releasing a joint cyber reporting proposal, and the recent high-profile Colonial Pipeline hack.

These issues, in addition to the other priorities outlined in his testimony such as MMF reform, operational resilience, AI, Basel III finalization and the LIBOR transition, leaves Quarles with a very full slate ahead of him with less than five months remaining in his term as Vice Chair for Supervision. While it remains unclear how far these issues can be addressed during this period, these issues will undoubtedly be continued by his successor and will likely be approached carefully in conjunction with international regulators. 

Gensler testifies before House Appropriations Committee

Yesterday, SEC Chair Gary Gensler testified before the House Appropriations Committee. His remarks focused on the need for more funding for the agency, observing that the number of broker-dealers and individual investors have grown over the past four years while agency staff has declined by four percent. He also highlighted the increasing complexity of issues that the SEC requires resources to focus on, including:

  • Special Purpose Acquisition Companies (SPACs). Gensler noted the unprecedented rise of companies going public through SPACs - shell companies that first go public and then merge with a target company - with 700 S-1 filings this year alone as compared with 13 total in 2016. He explained that he asked SEC staff to make recommendations regarding potential rules for addressing policy issues raised by SPACs, including whether retail investors are getting sufficient information, whether they are being adequately protected, and whether the compensation models for SPAC sponsors and financial advisors are unfair to retail investors.

  • Cryptocurrency. Highlighting challenges for investor protection associated with the cryptocurrency market, including price volatility, potential for fraud, and lack of transparency as most digital assets are traded on unregulated exchanges, Gensler noted that he looks forward to working with other regulators to address these issues.

  • ESG disclosures. Gensler noted that he is awaiting staff recommendations regarding potential rules around climate risk and human capital disclosures, explaining that it will likely contain the initial steps in broader SEC efforts to update its disclosure regime. He noted that the agency will move “expeditiously” to address this issue.

  • Private funds. Gensler explained that the number and size of private equity and venture capital funds has grown significantly over the past five years, and these funds have demonstrated new strategies and structures. In response, he has asked staff to provide recommendations for enhanced reporting and disclosure, stressing that it is important to hold these funds responsible for violating requirements around disclosure, conflict of interest, liquidity and other areas.

  • Fintech. Explaining that the market volatility earlier this year around GameStop stock trading revealed policy questions around issues such as gamification, behavioral prompts and the use of data analytics, Gensler explained that the SEC is considering how to address these issues through examinations, enforcement and potential rulemakings.

  • Data analytics. Describing the current state of data analytics as “the very beginning of a rapidly-changing field,” Gensler explained that technological innovation has the potential to bring significant benefits to the financial services industry but also presents challenges around fairness, bias, and the robustness of the models themselves. He noted that he has asked the staff to examine these issues as well as focus on how the agency itself uses data analytics to improve its examination and enforcement functions.

  • Regulation Best Interest. Gensler noted that the SEC will implement the 2019 Best Interest rule in “ways that maximize investor protection” while keeping an open mind regarding whether any updates are necessary to “ensure that Regulation Best Interest lives up to the promise of its name.” 

Our Take

In what was essentially a request for additional funding for the SEC, Chair Gensler revealed a number of policy areas that we expect to be his primary focus for the early part of his term. Abundantly clear is that new requirements around ESG disclosures are coming, with Gensler’s remarks all but confirming that a rule on the issue is not a matter of if, but when. Echoing comments from his previous testimony on market volatility related to GameStop and Archegos, Gensler showed that he is taking these incidents seriously, and new guidance - or potentially requirements - around issues such as gamification of trading and disclosure of short positions could become a reality. Other issues such as cryptocurrency and responsible use of data analytics are also clear priorities, especially considering Gensler’s focus on them in his previous role in academia, but given the relatively nascent nature of regulating these activities we expect lengthy study periods and outreach to stakeholders before seeing any new rulemakings.

Regarding Regulation Best Interest, Gensler’s comments imply that he will be watching carefully to see whether the rule is adequately protecting investors or whether additional protections are needed. This could include expanding upon the rule, which requires broker-dealers to recommend “suitable” investments and provide adequate disclosures, to a more stringent obligation to only recommend products in the “best interest” of the client as recommended in dissents from Democratic Commissioners Kara Stein and Robert Jackson. However, as most firms have long adjusted their business models in preparation for the now-defunct Department of Labor Best Interest rule, it remains to be seen whether a stronger standard will be needed. Going forward, we expect to see more concrete details around Gensler’s near-term priorities upon publication of the SEC’s Regulatory Flexibility Agenda, which we expect to come in the next several weeks. Stay tuned. 

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Julien Courbe

Financial Services Leader, PwC US

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