Our Take: financial services regulatory update – January 19, 2024 (2024)

• What happened: On January 18th, Acting Comptroller of the Currency Michael Hsu spoke on bank liquidity.
• What Hsu said:He summarized several dynamics that contributed to the bank failures last spring, including high volumes of uninsured deposits, rapid withdrawals among highly connected customers, difficulty monetizing liquid assets, contagion to banks with the perception of similar profiles, and issues using the Fed’s discount window including a stigma that it indicates weakness. Hsu confirmed some adaptation to these dynamics “has already taken place through supervision” and offered potential options to enhance regulations to more formally address them:
  • a. Recognize the potential for acute deposit outflows. He noted that higher risk deposits, including those that are uninsured and held by customers prone to “herding,” are currently subject to the same standard 10% outflow rate assumption for the liquidity coverage ratio (LCR) as all “retail demand deposits.” He argued that this assumption proved insufficient in light of the bank failures when deposit outflows were more severe than during the global financial crisis, evidencing new characteristics of modern bank runs.
  • b.Introduce a new ultra-short-term liquidity requirement. Hsu suggested a new liquidity ratio evaluating the ability of “midsize and large” banks to cover stress outflows over a short-term period, such as five days. The denominator would account for the “potential speed and severity of uninsured deposit outflows” and the numerator would incorporate pre-positioned discount window collateral. Hsu was clear to differentiate this from the existing LCR rule which prohibits reliance on the discount window and requires firms to cover 30-day stressed outflows with on-balance sheet, unencumbered High Quality Liquid Assets (HQLA). He also said the requirement should include clear expectations for operational preparedness to use the discount window, including for collateral pre-positioning.
  • c.Clarify the classifications of deposit types. Describing difficulty for market participants to distinguish which banks are subject to similar risks as those experiencing stress, leading to contagion through “guilt by association,” Hsu announced that the OCC would host a symposium in June to better understand and differentiate deposit types in order to promote market clarity and manage potential contagion events.

Hsu concluded with several other trends impacting liquidity risk management like faster payments and tokenization, expressing that continued efforts to remove frictions in the financial system and pursue digitally-enabled, “always-on” experiences present new risks and necessitate new controls.

• Background: These remarks follow several speeches last year by Fed Vice Chair for Supervision (VCS) Michael Barr on the importance of overcoming issues with both preparedness and stigma around using the discount window. Also, last July, the Fed, FDIC, OCC, and NCUA updated their existing guidance on liquidity risks and contingency planning with explicit attention to use of the discount window and the Federal Home Loan Bank system.

Our Take

A preview of formal liquidity requirements with many open questions. Hsu’s remarks are just the latest in a line of public comments and guidance to adapt liquidity risk frameworks for digital-age bank runs, including to more thoroughly incorporate the discount window into bank contingency funding plans. Although past speeches show Barr and Hsu agree on the need for action regarding the stigma with discount window usage, Hsu was careful to state that a new requirement would target its use in response to acute stress rather than “in good times and bad,” as suggested by Barr. While the regulators aim to reduce the discount window stigma, it remains unclear how mandating coverage and testing would relieve banks from the consequences of potentially signaling stress. Similarly, although the OCC symposium is intended to evaluate new methods for classifying deposits in an effort to address contagion, mitigating concerns around market perceptions of “guilt by association” will be easier said than done.

Broader changes to the LCR? Hsu was clear that a new ultra-short-term ratio would be distinct from the LCR but his inclusion of midsize banks serves as a reminder that the Fed’s tailoring framework provided LCR relief for most banks with under $250 billion in assets, to the point of removing it entirely for some. If midsize banks would be subject to a new ultra-short-term ratio, it is possible regulators are also considering re-expanding the applicability of the LCR. Although they have likely been deliberating this topic since the bank failures, it will take time for the three agencies to formulate and agree on such a significant proposal - particularly as they focus on finalizing Basel III endgame.

What should banks do now? Many banks have already recalibrated liquidity stress tests and contingency funding plans to incorporate lessons learned from last spring, including increasing the assumed severity of deposit outflows. Implementing a formal metric to demonstrate coverage of an acute short-term stress should not be a large operational lift or introduce a new binding constraint for most large financial institutions. Even before a formal requirement is proposed or finalized, banks should take action to formalize new short-term scenarios into their regular suite of ongoing liquidity stress tests. In particular, because midsize banks have not had the same level of regulatory scrutiny compared to their large bank counterparts, they may need to take additional steps to enhance liquidity modeling, collateral prepositioning and operational capabilities to prepare for new requirements.

• What happened: On January 17th, the CFPB released a proposal to limit overdraft fees charged when a customer’s account has insufficient funds to cover a transaction. President Biden expressed his support for the proposal, stating that it would cut the average overdraft fee by more than half.
• What the proposal says: The proposal would cap overdraft fees charged by banks with $10 billion or more in total assets to the amount equal to the cost and losses associated with providing the service. It would give banks the following options:
  • a.Charging a benchmark fee set by the CFPB. The proposal does not specify what the fee would be but presents options ranging from $3 to $14;
  • b.Charging a “break-even fee” determined by the bank’s own calculations; or
  • c.Treating overdraft coverage as a line of credit. Banks that do so would be required to follow rules governing other credit transactions, including those around disclosures, interest rates and repayment.
• What’s next: Comments on the proposal must be received on or before April 1st, 2024. The CFPB aims to have the final rule go into effect on October 1st, 2025.

Our Take

Many banks have already eliminated or modified their overdraft fees over the past several years, especially following the CFPB’s repeated calls to address potential unfair, deceptive or abusive acts and practices (UDAAP) related to these fees. However, the agency’s research shows that the majority of firms still charge an average of $35 per overdraft.

What should banks do now? With prescriptive rules on the way, banks that still charge overdraft fees should consider the following:

• Develop documentation, including a cost analysis, to prove that the fees are necessary to cover their costs.
• Banks that rely on overdraft fees for a significant source of revenue should determine the proposal’s potential financial impact.

As all “junk fees” including those beyond overdraft fees are a key Administration priority, we expect to see continued action - including enforcement - from the CFPB during this election year. As such, all financial institutions should make sure that they:

• Have a catalog of all of their fees, including rationale for how they are determined;
• Make sure that fees are disclosed clearly and match how they are charged in practice; and
• Review their pricing models, especially with regard to impact on vulnerable customers.

• What happened: On January 17th, the Fed and the FDIC (together, the Agencies) extended the resolution plan submission deadline for certain large financial institutions. These companies will be required to submit their resolution plans by March 31st, 2025 instead of July 1st, 2024.
• Background: On August 29th, the Agencies issued several proposals related to resolution planning, including long term debt requirements and enhanced resolution planning requirements for insured depository institutions (IDIs) with over $50 billion in assets as well as guidance for both US banks and foreign banking organizations (FBOs) with over $250 billion in assets in Categories II and III of the Fed’s tailoring framework. The comment period for the guidance closed on November 30th, 2023.
• What’s next: A memo recommending the extension states that FDIC staff hope to present final guidance for consideration by the agency Boards in March 2024 with the aim of finalizing it one year before the next plans are due.

Our Take

More time to meet a higher standard. The affected banks will have a nine month reprieve on submitting their next resolution plans with the tradeoff of having to be fully compliant with the final guidance. Institutions will have a year to adapt to the guidance which many will need as it would likely meaningfully heighten capability expectations.

What should banks do now? Banks should not wait to start doing capability assessments based on the proposed guidance. With the additional time, some may decide to amend their resolution strategies from multiple point of entry (MPOE) to single point of entry (SPOE). Most filers will need significant capability enhancements, with capital and liquidity analysis, governance triggers and playbooks, operational capabilities including analysis related to qualified financial contracts, legal entity rationalization, and separability among the most substantial.

These notable developments hit our radar this week:

• Barr speaks on cyber risk. On January 17th, Fed VCS Michael Barr spoke on cyber risk, third party risk management and operational resilience. He expressed the need for more complete data on cyber risks and interconnections between financial institutions and service providers.
• OCC issues bulletin on shortening the settlement cycle. On January 17th, the OCC released a bulletin to highlight actions that banks should take to prepare for the standard securities settlement cycle to change from two days after the trade date (T+2) to one day (T+1) by May 28, 2024.
• Regulators participate in AI panel. On January 19th, Fed VCS Michael Barr, OCC Acting Comptroller Michael Hsu, FDIC Chair Martin Gruenberg and CFPB Director Rohit Chopra participated in a panel on responsible AI.