Our take: financial services regulatory update – December 18, 2020

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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 – December 18, 2020

Fed releases additional 2020 stress test results, eases restrictions

Today, the Fed released the results of the additional stress test it announced after the standard 2020 Comprehensive Capital Analysis and Review (CCAR) cycle was not able to fully assess the effects of the pandemic. All 33 banks remained above their capital minimums. Firms with capital markets businesses, which have been resilient during COVID, fared positively in the evaluation. 

As a result, the Fed eased the restrictions on distributions it implemented following the June 2020 CCAR results. Banks will now be able to (a) pay dividends up to the level they paid in Q2 and (b) pay dividends and make share repurchases in Q1 2021 up to an amount equal to the average of their net income for the four prior quarters. The Fed had previously capped dividends at these levels and suspended share repurchases entirely for Q3 and Q4. Governor Lael Brainard dissented from the decision to ease the earlier restrictions, which she already believed did not go far enough.

Altogether, the banks would have $600b in losses under the two new severe scenarios whereas they would have had $550b under the original CCAR severely adverse scenario released in February 2020. The Fed announced that it would not use these results to adjust banks’ capital requirements via the stress capital buffer (SCB), which was finalized in March to formally incorporate Fed-modeled start-to-trough stressed capital depletions into ongoing capital requirements. The Fed can adjust ongoing capital requirements through new capital depletion projections and although it opted not to do so at this time, it extended its notice period to make an adjustment through Q1 2021. 

Our take

This result is a welcome holiday surprise, particularly for the large banks. The Fed recognized that they have weathered the storm while shoring up capital and setting aside an additional $100b in reserves. Accordingly, it loosened restrictions to allow many banks to materially increase distributions to shareholders. While some restrictions remain, the increased flexibility will be well received by the banks that are able to take advantage of it. Some of the smaller banks in the stress testing cohort – which do not have the large banks’ trading and asset management income to offset industry-wide hits to commercial real estate and credit portfolios – may have less flexibility to increase distributions.

Looking ahead, we expect the Fed to reset firms’ SCBs following CCAR 2021 but it remains to be seen whether it will allow full flexibility to make distributions within the bounds of the SCB or consider it necessary to continue overlaying blanket restrictions. With the vaccine roll out and signs of sustained economic recovery, banks may have reason to expect a return to some sense of normalcy next summer. That said, this crisis has demonstrated a need for both the banks and the Fed itself to widen the aperture of potential stress and prepare for a variety of scenarios including other pandemics, large scale cyber attacks, and environmental disruptions. In this vein, the Fed likely will continue to enhance and refine its stress capital models, which could lead to higher capital requirements through the SCB.

FDIC finalizes ILC charter framework

On Tuesday, the FDIC also finalized its new framework for nonfinancial firms seeking industrial loan company (ILC) charters. Companies that receive ILC charters can partake in the same general set of activities as federal banks, but unlike OCC-chartered institutions they can have commercial firms as parent companies. Under the framework, parent companies of ILCs, and certain investors at the discretion of the FDIC, would have to sign contractual agreements with the FDIC, making a number of commitments including to be the source of strength in times of stress; essentially ensuring the adequacy of an ILC’s capital and liquidity. They would also have to provide a list of all their subsidiaries, undergo examinations, submit an annual report, comply with recordkeeping requirements, limit their board membership in the ILC to no more than 50% and maintain sufficient capital and liquidity. The FDIC notes that ILC-chartered institutions will be subject to the same regulatory expectations as any state-chartered bank that is not a part of the Federal Reserve system and they will have capital and liquidity requirements that are significantly higher than other insured banks.

Earlier this year, the FDIC granted ILC charters to mobile payments fintech Square, Inc. and student loan administrator Nelnet, Inc. A large e-commerce platform recently applied for ILC charters. Yesterday, the Bank Policy Institute, Center for Responsible Lending and the Independent Community Bankers of America issued a statement calling on Congress to prohibit the FDIC from approving ILC charters.

Our take

This year has seen fintechs and other firms take a wide variety of chartering approaches, with several firms successfully obtaining federal banking and ILC charters while others have essentially purchased charters by acquiring banks. While we expect fintechs to continue weighing their options as to which route is more attractive, nonfinancial firms are limited to the ILC charter. Despite the FDIC clearing this path somewhat by providing more transparent guidelines, companies will have to carefully evaluate the framework’s high expectations before proceeding. For smaller companies, the contractual obligation to be on the hook for their ILC subsidiary - in addition to existing limits on the ability to use or withdraw funds from the ILC - may cause them to reevaluate the pros and cons of pursuing this charting option. Large nonfinancial companies will also likely face obstacles as there has been bipartisan support for legislation to prevent them from obtaining an ILC charter, and if they were to submit an application they would likely see significant opposition from politicians, regulators, consumer groups and the banking industry alike.

Banking agencies propose cyber reporting requirements

On Tuesday, the Fed, OCC, and FDIC proposed a rule that would require banks to notify their primary federal regulator of “significant computer security incidents” within 36 hours. Currently, banks are required to report cyber incidents to federal regulators “as soon as possible,” and those licensed by the New York Department of Financial Services are subject to its 72-hour breach notification requirement. The proposal defines “significant” incidents as those that could result in material financial losses, disrupt the ability to carry out operations to serve customers, or impair operations that are critical to financial stability. At present, notice is only required for unauthorized access to or use of sensitive customer information.

The proposal will be open for comment for 90 days following publication in the Federal Register.

Our take

The regulators continue to up the game on cyber. The proposal is a continued recognition of the interconnectedness and interdependencies of the financial ecosystem, under which a significant cyber incident at one firm can cause ripple effects across the entire industry. To help prevent this, the agencies need timely information about disruptions from institutions just as much as these institutions need the same from their critical service providers. By specifying a 36-hour timeline for reporting, the agencies are drawing a clear line in the sand that firms need to share information critical to maintaining stability of the sector immediately. Doing so not only helps the rest of the sector react, it also helps instill consumer confidence by adding transparency and time for consumers to assess potential exposure. While many industry participants have prepared to report within 72 hours to NYDFS, adjusting to this stricter requirement could pose some operational challenges. For example, firms will have to work with their risk and compliance teams to carefully determine and document which incidents rise to the proposed definition of “significant incidents” that require reporting and retain documentation for examination. This will also require a reassessment of what information is shared with consumers, particularly given that after 36 hours the full extent of the incident may still be undetermined

DOL finalizes fiduciary rule replacement

On Tuesday, the DOL finalized its exemption for investment advice fiduciaries under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code. The exemption permits fiduciaries to receive otherwise prohibited forms of compensation such as commissions as long as their advice is in the best interest of the customer and they disclose any conflicts of interest. It replaces the 2016 fiduciary rule that was vacated in 2018 and aligns with the SEC’s best interest rule that went into effect earlier this year. 

The exemption does not adopt the 2016 rule’s definition of a “fiduciary” and instead reaffirms the DOL’s long-standing five-part test that has been in place since 1975.[1] It includes some of the requirements that were in the vacated rule, particularly its provision that advisors on rollovers from employee benefit plans to IRAs who intend to provide ongoing investment advice on the rollover funds meet the fiduciary definition, but it does not require a contract or allow for a private right of action.

The exemption will be effective 60 days after publication in the Federal Register, and firms will have a one year transition period after its publication to comply.

The DOL’s five-part test for determining whether an entity is a fiduciary is whether they 1) render investment advice; 2) on a regular basis; (3) pursuant to a mutual agreement; (4) that the advice will serve as a primary basis for investment decisions. and (5) the advice will be individualized based on particular needs.

Our take

The industry breathed a sigh of relief when the 2016 rule was vacated and welcomed the much less disruptive new standard when it was proposed earlier this year. It will still have significant impact for rollovers and will entail a fair number of changes to disclosures, operations, policies and procedures. That said, any new burden for firms will be significantly mitigated as many will be able to leverage the work they have done to comply with the 2016 rule or the SEC’s best interest rule. Considering that the rule will not go into effect until after the transition to the Biden Administration, it is highly likely that it will get delayed and later revised to include stronger protections championed by Democrats such as a broader definition of a “fiduciary” and more specific criteria around what constitutes a customer’s “best interest.”

[1] The DOL’s five-part test for determining whether an entity is a fiduciary is whether they 1) render investment advice; 2) on a regular basis; (3) pursuant to a mutual agreement; (4) that the advice will serve as a primary basis for investment decisions. and (5) the advice will be individualized based on particular needs.

FDIC finalizes brokered deposits framework

On Tuesday, the FDIC finalized revisions to its regulations on brokered deposits set to take effect in 2022. The final rule establishes a new framework for determining whether certain deposits qualify as brokered, revises the deposit broker definition and amends a key exception to that definition.

The new three-part deposit broker definition removes an element included in the proposal that would have brought into scope persons that directly or indirectly share customer information with an IDI in response to feedback that this definition would be overly broad. In addition, the final rule newly specifies that an entity with an exclusive deposit placement arrangement with one IDI would not meet the definition of a deposit broker. It also extends the “primary purpose exemption,” which applies when the placement of deposits with an IDI is not an agent’s primary business, to a number of arrangements including health savings accounts and deposits to facilitate certain transactions.

FDIC Chairman Jelena McWilliams repeated her call for Congress to change the law to have a cap on asset growth rather than an outright restriction on accepting brokered deposits for banks with insufficient capital levels.

The final rule’s revised deposit broker definition provides significant relief to banks with affiliates that have exclusive relationships to refer deposits as these would no longer be classified as brokered deposits. This change also recognizes and eases the increasing popularity of fintech partnerships that provide such exclusive deposit referrals. Banks will also welcome the removal of the information sharing element of the definition as it would have significantly complicated their deposit classifications. However, banking organizations will still need to revise their data taxonomies and deposit characterization processes in order to realize benefits of the narrower deposit broker definition and broader primary purpose exemption.

[2] An entity is considered a deposit broker if they either 1) have legal authority to move customer funds to an insured depository institution (IDI); 2) are involved in negotiating or setting rates, fees, terms or conditions for the deposit account; or 3) engage in “matchmaking services” or proposing deposit allocations based on the objectives of both a depositor and an IDI. would have significantly complicated their deposit classifications. However, banking organizations will still need to revise their data taxonomies and deposit characterization processes in order to realize benefits of the narrower deposit broker definition and broader primary purpose exemption.

Our take

The final rule’s revised deposit broker definition provides significant relief to banks with affiliates that have exclusive relationships to refer deposits as these would no longer be classified as brokered deposits. This change also recognizes and eases the increasing popularity of fintech partnerships that provide such exclusive deposit referrals. Banks will also welcome the removal of the information sharing element of the definition as it 

On our radar

On our radar: These notable developments hit our radar over the past week:

  • LIBOR Transition: Industry groups remain concerned about legacy contracts and readiness to issue new products in alternative reference rates:
    • On Wednesday, SIFMA joined numerous trade organizations in an appeal to the New York State legislature to take swift action on a legislative proposal brought forward by the Alternative Reference Rate Committee (ARRC). Upon LIBOR’s cessation, the proposed legislation would facilitate a statutory replacement of LIBOR in contracts without provisions that would address a permanent discontinuation of the benchmark.
    • Yesterday, the Working Group on Sterling Risk-Free Reference Rates published an open letter to loan and treasury management system providers, highlighting that there was a “material reliance on timely delivery” of software changes needed to transact in alternative reference rates. The working group has set a regulator endorsed target date of Q1 2021 for market participants to end new GBP LIBOR lending. In the US market, where firms tend to rely on many of the same third party service providers, supervisors expect banks to end the use of USD LIBOR in new products “as soon as practicable”, but no later than December 31, 2021.

Subscribe to PwC’s LIBOR Transition Market Update here

  • Climate risk on the horizon. There were a number of actions concerning the impact of climate change risk on financial services this week:
    • Climate risk bill introduced in Congress. Yesterday, Sen. Dianne Feinstein (D-CA) introduced legislation that would establish a 12-member subcommittee within the FSOC to examine climate risks within the financial system and require that federal banking regulators update their supervisory guidance to include climate risk.
    • Fed joins central bank climate risk network. On Tuesday, the Fed announced that it has formally joined the Network of Central Banks and Supervisors for Greening the Financial System, a consortium of central banks with the purpose of exchanging ideas and developing best practices for addressing climate risk in the financial sector.
    • Center for American Progress holds conference. Today, the Center for American Progress held a conference on the regulatory imperative to address climate change featuring remarks from Fed Governor Lael Brainard, FDIC Board Member Martin Gruenberg, NYDFS Superintendent Linda Lacewell and Democratic Commissioners from the SEC and CFTC. Their comments substantiated expectations that climate risk will be a key priority under Democrat-led regulators including potential efforts to increase disclosures and require scenario analysis.
  • Huntington and TCF to merge. On Sunday, Huntington Bancshares and TCF Financial announced that they would merge in an all-stock deal. The merged institution will continue to operate under the Huntington name and will have approximately $168 billion in assets.

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Julien Courbe

Financial Services Leader, PwC US

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