FOR THE RECORD 9 Jeremy Newell, THE QUARTERLY JOURNAL OF THE CLEARING HOUSE Q3 2017, VOLUME 5, ISSUE 3 The Clearing House
MY PERSPECTIVE 14 H. Rodgin Cohen, Sullivan & Cromwell
STATE OF BANKING 18 Greg Carmichael, Fifth Third
Rethinking Bank Regulation & Supervision Carine Joannou Carine JoannouPRESIDENT JAMIS BICYCLES PRESIDENT JAMIS BICYCLES
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UPFRONT FEATURED ARTICLES
For the Record Structural Limitations and 9 Regulators demand banking practices that are 30 Activity Restrictions static and standardized, which hurts innovation, Regs should not protect people from risks they knowingly competition, expansion, and change. accept, while firms that absorb more of their own losses by Jeremy Newell, Executive Managing Director, do not need to be heavily regulated. Head of Regulatory Affairs, and General Counsel, The Clearing House Association by Norbert Michel, The Heritage Foundation
My Perspective Rethinking Safety and 14 The conclusion that E. Gerald Corrigan reached in Soundness Supervision 1982 – that banks are special – is still true today. 42 It’s worth revisiting his work for a second time. Consumer compliance and safety and soundness should be reviewed separately. And the processes, guidelines, by H. Rodgin Cohen, Senior Chairman, and regulations need considerable reforms. Sullivan & Cromwell by Greg Baer, The Clearing House
Stress Tests: Restore 54 Compliance with the APA Supervisory practices at the Federal Reserve must be reformed to restore compliance with the Administrative Procedure Act, especially for stress tests. by Hal S. Scott, Harvard Law School
Improving Appeals of 60 Material Supervisory Determinations Financial institutions rarely use the intra-agency process to appeal bank examiner decisions. Here are three suggestions to improve the system. by Julie Andersen Hill, University of Alabama School of Law STATE OF BANKING Greg Carmichael, Banks’ Own Models Should 18 Fifth Third Bancorp 70 Play a Role in Supervisory Greg Carmichael, CEO of Fifth Third Bancorp, Stress Tests discusses the impact of regulations on the industry, Including banks’ own models in supervisory stress tests and the relationship between FinTechs and banks would reduce the uncertainty around capital planning, with TCH’s Jim Aramanda. increase efficiency, and expand credit availability. by Francisco Covas, The Clearing House
4 BANKING PERSPECTIVES QUARTER 3 2017 EDITOR Greg MacSweeney
DESIGN & PRODUCTION Big Yellow Taxi, Inc.
Banking Perspectives is the quarterly journal of The Clearing House. Its aim is to inform financial industry leaders and the policymaking community on developments in bank policy and payments. The journal is a forum for thought leadership from banking industry executives, regulators, academics, policy experts, industry observers, and others.
70 Established in 1853, The Clearing House is the oldest banking association and payments company in the United Why Banking Systems Today States. It is owned by the world’s largest commercial banks, 76 Are More Unstable Than Ever which collectively hold more than half of all U.S. deposits The usual two culprits named after a bank crisis occurs and which employ over 1 million people in the United don’t do a very good job of explaining what caused the States and more than 2 million people worldwide. The problem. It’s time for a broader view. Clearing House Association L.L.C. is a nonpartisan advocacy organization that represents the interests of its owner by Charles W. Calomiris, Columbia Business School banks by developing and promoting policies to support a safe, sound, and competitive banking system that serves The Role of the Board customers and communities. Its affiliate, The Clearing 82 in the Transforming House Payments Company L.L.C., which is regulated as a Banking Industry systemically important financial market utility, owns and The separation of responsibilities between the board of operates payments technology infrastructure that provides directors and senior management must be clarified and safe and efficient payment, clearing, and settlement maintained as the industry evolves and changes. services to financial institutions, and leads innovation and by Paul Harris, KeyBank, and thought leadership activities for the next generation of Gregg Rozansky, The Clearing House payments. It clears almost $2 trillion each day, representing nearly half of all automated clearing house, funds transfer, and check-image payments made in the U.S. DEPARTMENTS Copyright 2017 The Clearing House Association L.L.C. All Contributors rights reserved. All content is owned by The Clearing House Association L.L.C. or its licensors. The views expressed Information on the authors from this edition. 6 herein are not necessarily those of The Clearing House Association L.L.C., its affiliates, customers, or owners. Any TCH Bank Conditions Index use or reproduction of any of the contents hereof without 90 A quantitative assessment of the resiliency of the U.S. the express written permission of The Clearing House banking sector. Association L.L.C. is strictly prohibited.
Research Rundown The Clearing House 92 Highlights from academic research on banking issues. 1114 Avenue of the Americas 1001 Pennsylvania Avenue, NW New York, NY 10036 Washington, DC 20004 212.613.0100 202.649.4600 BANKING PERSPECTIVES QUARTER 3 2017 5 Contributors
Greg Baer Business School’s Program for Financial Banking Supervision & Regulation focusing Studies and its Initiative on Finance and on a range of capital, liquidity, and other Greg Baer is Growth in Emerging Markets, and a professor regulatory initiatives. He previously worked at President of The at Columbia’s School of International and the central banks of Portugal and Canada. Clearing House Public Affairs. His research spans the areas Association and of banking, corporate finance, financial Covas earned a Ph.D. in economics from Executive Vice history, and monetary economics. the University of California, San Diego, in President and 2004 and a B.A. from the Universidade Nova General Counsel of He is a Distinguished Visiting Fellow de Lisboa, Portugal, in 1997. The Clearing House at the Hoover Institution, a Fellow at the Payments Co. Prior Manhattan Institute, a member of the Paul Harris to joining TCH, Baer was Managing Director Shadow Open Market Committee and the and Head of Regulatory Policy at JPMorgan Financial Economists Roundtable, and a Paul Harris is Chase. He previously served as General Research Associate of the National Bureau Secretary and Counsel for Corporate and Regulatory Law at of Economic Research. He received a B.A. General Counsel JPMorgan Chase. in economics from Yale University, magna of KeyCorp and cum laude, and a Ph.D. in economics from oversees the Baer previously served as Deputy General Stanford University. corporation’s legal Counsel for Corporate Law at Bank of America, and government and as a partner at Wilmer, Cutler, Pickering, Francisco Covas relations Hale & Dorr. From 1999 to 2001, he served as functions. Prior to Assistant Secretary for Financial Institutions at Francisco Covas is joining KeyCorp in 2003, Harris served as the U.S. Department of the Treasury, after serving Senior Vice partner-in-charge of the Cleveland office of as Deputy Assistant Secretary. Prior to working President and Thompson Hine LLP. Harris serves on behalf for the Treasury Department, he was managing Deputy Head of of KeyCorp as a member of The Clearing senior counsel at the Board of Governors of the Research, The House Association Managing Board of Federal Reserve System. Baer received his J.D. Clearing House Directors and is a past Chair of the cum laude from Harvard Law School in 1987. He Association. Association and current Chair of the received his A.B. with honors from the University Covas contributes Association’s Governance Committee. He is of North Carolina at Chapel Hill in 1984. research and a past President (2007–2008) of the Ohio analysis to support the advocacy of the Chapter of the Society for Corporate Charles W. Calomiris Association on behalf of the owner banks. Governance (formerly known as the Society of Corporate Secretaries & Governance Charles W. Prior to joining The Clearing House in 2016, Professionals, Inc.). Harris received a Calomiris is Henry he was an assistant director of the Division of bachelor of arts degree from the University Kaufman Monetary Affairs at the Federal Reserve Board, of Chicago and his jurisprudence degree Professor of where he supervised a team focused on the from Stanford Law School. Financial role of banks in the transmission of monetary Institutions at policy as well as on the effects of changes Columbia in bank regulation on monetary policy. Covas Business School, joined the Board in 2007 as an economist in Director of the the Quantitative Risk Management section of
6 BANKING PERSPECTIVES QUARTER 3 2017 Julie Andersen Hill Heritage’s Roe Institute for Economic Policy Gottlieb Steen & Hamilton and Shearman & Studies, Michel also focuses on the best way Sterling. He is a graduate of Harvard Law Professor Julie to address difficulties at large financial School and earned his B.A. in economics and Andersen Hill companies (the “too big to fail” problem). government at Cornell University. joined the University of Before rejoining Heritage in 2013, Michel Hal S. Scott Alabama School was a tenured professor at Nicholls State of Law in 2013. University’s College of Business, teaching Hal S. Scott is the She previously finance, economics, and statistics at the Nomura Professor was a faculty AACSB-accredited school in Thibodaux, La. and Director of member at the His earlier stint at Heritage was as a tax policy the Program on University of Houston Law Center. Hill analyst in the think tank’s Center for Data International teaches in the areas of banking and Analysis from 2002 to 2005. Financial Systems commercial law. She is a recognized expert (PIFS) at Harvard on financial institution regulation. In 2015, Michel holds a doctoral degree in Law School, the University of Alabama awarded Hill the financial economics from the University of where he has President’s Faculty Research Award. She New Orleans. He received his bachelor of taught since 1975. previously practiced law in the Washington, business administration degree in finance and D.C., office of Skadden, Arps, Slate, Meagher economics from Loyola University. Scott has a B.A. from Princeton University & Flom. As part of the litigation group, she (Woodrow Wilson School, 1965), an M.A. from represented large financial institutions under Gregg Rozansky Stanford University in political science (1967), government investigation. and a J.D. from the University of Chicago Law Gregg Rozansky is School (1972). In 1974–1975, before joining Hill received her undergraduate degree in Managing Director Harvard, he clerked for Justice Byron White. economics summa cum laude from Southern and Senior Utah University. She earned her J.D. degree Associate General Scott is the Director of the Committee summa cum laude from the J. Reuben Clark Counsel of The on Capital Markets Regulation, a bipartisan Law School at Brigham Young University. Hill Clearing House. nonprofit organization dedicated to enhancing clerked for Judge Wade Brorby on the United Rozansky leads the the competitiveness of U.S. capital markets State Court of Appeals for the Tenth Circuit. policy efforts of and ensuring the stability of the U.S. financial TCH on an array of system via research and advocacy. He is also Norbert Michel bank regulatory, compliance, and corporate a member of the Bretton Woods Committee, governance-related issues affecting large a member of the Market Monitoring Group of Norbert Michel financial institutions. He is a frequent presenter the Institute of International Finance, a past studies and writes on bank corporate governance and regulatory Independent Director of Lazard, Ltd. (2006– about financial issues at leading financial industry events and 2016), a past President of the International markets and has written extensively on the regulation of Academy of Consumer and Commercial Law, monetary policy, major banking institutions and regulatory and a past Governor of the American Stock including the reform, including the Dodd-Frank Act. Prior to Exchange (2002–2005). n reform of Fannie joining TCH in 2013, Rozansky advised financial Mae and Freddie institutions on U.S. bank regulatory and Mac. Working in compliance issues in private practice at Cleary
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SunTrust Bank, Member FDIC. ©2017 SunTrust Banks, Inc. SUNTRUST and the SunTrust logo are trademarks of SunTrust Banks, Inc. All rights reserved. MOM-386403-10826017-17 CONFIDENCE STARTS HERE MY PERSPECTIVE STATE OF BANKING H. RODGIN COHEN, GREG CARMICHAEL SULLIVAN & CROMWELL Fifth Third’s CEO discusses innovation Are Banks Special? and technology, customer focus, and A Re-Revisitation tweaking bank regulations. P.14 UPFRONT P.18
FOR THE RECORD Rethinking Banking’s Regulatory Framework BY JEREMY NEWELL, THE CLEARING HOUSE
In this issue of Banking The capital reforms undertaken by the Basel those standards they negotiated internationally Perspectives, we take stock Committee are perhaps the best example of this and made them more stringent (which they of the post-crisis bank phenomenon. Since 2009, the Basel Committee refer to as “gold plating”) for U.S. banks. All regulatory framework, with has proposed or finalized a large number of these changes have been pursued separately contributions from experts different changes to its capital framework, and iteratively, and the result is a capital who identify aspects of some of which have established new minimum adequacy regime that is not coherent in any the framework that merit ratios, some of which have redefined that ratio’s real sense, but is simply the sum of numerous rethinking. This fresh look at numerator (i.e., the definitions of capital), parts that have each been designed and the post-crisis “big picture” seems appropriate, and many of which have redefined the many calibrated in their own vacuum. not only because nearly a decade has passed subcomponents of that ratio’s denominator since the worst of the financial crisis abated, (e.g., the separate risk-weighting frameworks That conclusion is not intended to be overly but also because of the rapid and fragmented for credit risk, market risk, operational risk, critical – following the most pronounced way that picture was painted in the first place. etc.). U.S. regulators have generally then taken financial crisis in nearly a century, the Indeed, it is easy to lose sight of the fact that the post-crisis regulatory framework was not developed in any holistic, systematic way, but rather is an amalgamation of numerous new standards and policies that were individually designed through independent processes, by a wide range of domestic and international regulators, without the benefit of any comprehensive understanding of their collective and cumulative effects.
JEREMY NEWELL is Executive Managing Director, Head of Regulatory Affairs, and General Counsel of The Clearing House Association. Newell has previously worked as counsel and policy advisor at WilmerHale, the Board of Governors of the Federal Reserve System, American Express, Natixis, and Sullivan & Cromwell. Newell received his J.D. from Yale Law School.
BANKING PERSPECTIVES QUARTER 3 2017 9 For the Record
Regulators and supervisors have come to a centrally planned banking system, where it is they who do all the planning and define the effectively embrace a centrally planned criteria for compliance. banking system where it is they who do all the The first of these trends – the overwhelming planning and define the criteria for compliance. reliance on standardization of banking practices through regulation – is easier to identify. It is most pronounced in the new framework of regulatory community was rightly on a University economist Charles Calomiris assesses “balance sheet” regulation, where the complex war footing, and the rapid issuance of new the direction of financial regulation through and granular nature of new capital and liquidity regulatory standards was consistent with the the prism of two regulatory drivers of financial rules has resulted in an unprecedented level urgency of the task of assuring the resilience instability – government policies to protect bank of regulatory prescription around how nearly of the banking system. But – especially now losses and encourage real estate lending – and every aspect of a bank balance sheet should that such resilience undoubtedly is in place – concludes their impact is important and growing. be constructed and managed. That regulatory it does seem fair to ask what all of these new prescription certainly has its benefits – chief regulatory parts add up to, and whether that On a related front, my colleague Greg Baer among them, a vastly more resilient profile across sum is as coherent and sensible as it could be. follows up with some answers to the questions the banking industry. But it also gives rise to a raised in our recent article, “How Supervision world in which bank balance sheets must, as a It is precisely this type of “big picture” Has Lost Its Way.” Increasingly, we hear from function of that regulatory nanoengineering, assessment that is undertaken by this issue’s banks of all sizes that problems with the be organized and managed in an increasingly authors. H. Rodgin Cohen begins this journey generally secret supervisory process are just homogeneous and standardized way, with little by revisiting former New York Fed President as significant for their ability to serve their room to stray from the mostly one-size-fits-all Gerald Corrigan’s famous argument regarding customers as problems with the public regulatory model enshrined in these new rules. the “specialness” of banks as the basis for bank process. We continue our efforts to explain what regulation, and highlights the extent to which is going on and how it could be improved. A similar trend toward standardization enforcement of banking regulation seems to is observable across many other post- have become untethered to the core safety The subject matter of these articles is diverse, crisis rules: Resolution planning at every and soundness objective that has traditionally but they all share one trait: a willingness to bank must meet a single, detailed set of guided it. Professors Julie Andersen Hill and rethink where the post-crisis reform process regulatory preferences; leveraged loans must Hal Scott focus on procedural problems in the has landed. It is our hope that these articles be underwritten, originated, and managed existing regulatory framework – with Prof. Hill provide ample opportunity for thought as to according to practices specified by regulators; highlighting the ineffectiveness of the existing how to continue to improve and adapt our all risk-taking must be managed and governed process by which material supervisory decisions framework of bank regulation. according to the Office of the Comptroller of may be reviewed and appealed, and Prof. Scott the Currency’s detailed “three lines of defense” demonstrating how the Federal Reserve’s stress- To this list of things worth “rethinking,” I model; vendors must be vetted, approved, testing exercise may run afoul of both the letter would add an observation of my own, which and managed according the agencies’ latest and spirit of the Administrative Procedure Act. is the emergence of two mutually reinforcing preferences; bank directors must adhere to a The Heritage Foundation’s Norbert Michel takes and pernicious trends that cut across nearly all hundred pages of precise instructions from on the broader objectives of bank regulation aspects of the new regulatory and supervisory regulators on how they must perform their and explores the link between an expanded paradigm: a regulatory demand for banking board duties. (On this last point, a recent federal safety net for banks and greater (and practices that are both standardized and static. Federal Reserve proposal gives reason for more intrusive) bank regulation – and argues Or, to put it more provocatively, regulators and hope, at least at the holding company level.) for rollback of both. And finally, Columbia supervisors have come to effectively embrace The list is seemingly endless.
10 BANKING PERSPECTIVES QUARTER 3 2017 Turn compliance into opportunity
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And this is to say nothing of all the The current supervisory dynamic operates as additional supervisory prescriptions being written by examiners and supervisory policy a substantial barrier to innovation, staff outside of public view. As any banker expansion, or change in the banking industry. can now attest, it has become depressingly common for bank supervisors to effectively invent their own standards for how banks should operate, in a process that is not and reinforced by a similarly pronounced lights theory of bank management – if one transparent, let alone subject to public regulatory preference for stasis in banking. thing is wrong, then everything must be comment, and demand conformance to those Simply put, the current supervisory wrong. And therefore if one thing is wrong expectations under penalty of examiner dynamic operates as a substantial barrier somewhere in a bank, then nothing can criticism or adverse action. As Greg Baer and to innovation, expansion, or change in the change anywhere in that bank. I have detailed previously in this journal, the banking industry. On the surface, this trend rise of such extralegal (and therefore illegal) is less readily apparent than the push for The practical implications of that banking rules is one of the great untold stories standardization, as it is largely the product of supervisory approach are predictable and of post-crisis regulatory reform. the opaque supervisory environment rather significant – an enormous and systematic than a transparent regulatory framework. But bias against innovation and change, both in None of this is to say that the growing beneath that surface, the supervisory process individual banks and across the industry. standardization of banking practices by has come to impose significant constraints on Again, this is not to argue against robust and regulatory fiat is without some social benefit. banks’ ability to make strategic acquisitions, meaningful supervisory checks on banks’ But it does mean that, as an overwhelming open new branches, or develop and offer new ability to expand and grow – certainly, trend across the post-crisis regime, it likely products or services and otherwise meet the supervisors can and should be able to prohibit has some social costs, too. Unfortunately, growing financial needs of their customers. supervised institutions from undertaking these social costs have not been much acquisitions or activities where they lack the acknowledged by policymakers, let alone In some cases, these constraints are managerial expertise or other resources to do analyzed. As with any attempt at central formal – for example, in 2014 the Federal so safely and soundly. planning, chief among them are the very real Reserve issued a “supervisory letter,” potential costs to innovation and efficiency referred to as SR 14-02, that identified But, ideally, such authority should be that would seem to come with the regulatory a range of supervisory concerns that as clearly articulated and vested in specific and “crowding out” of what ideally ought to be a matter of Federal Reserve practice (as accountable individuals. Unfortunately today’s a rich, varied, and competitive marketplace opposed to actual law or regulation) would, supervisory dynamic seems quite far from of different ideas and perspectives on how if present at a bank, preclude any acquisition that ideal – instead, it is increasingly the case best to run a bank. Also among them is the or expansion by that bank. There is no that the number of individual supervisors that not immaterial risk that the regulators’ new requirement therein that the supervisory effectively possess a veto right on acquisitions one-size-fits-all model of bank management concern actually relate to, let alone reflect or new activities across the entire supervised and operation may be revealed over time negatively upon, the proposed area of organization is not one or two but 10 or 20. to include one or more deep flaws that expansion – thus, for example, supervisory We should not be surprised if a supervisory endangers the core lending and other scrutiny of anti-money laundering practices model that imposes such significant and functions that banks perform, the stability of in one’s wealth management business could diffuse obstacles to innovation and change our financial system, or both. well operate as a total bar on opening a new should give rise to banking industry that is branch in an underserved community. The much less dynamic and adaptable than its The trend toward regulatory net result is a broad supervisory embrace customers would otherwise prefer and that standardization in banking is complemented of what might be called the Christmas-tree- international competitiveness demands. n
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For more information, visit www.shearman.com. MY PERSPECTIVE Are Banks Special? A Re-Revisitation BY H. RODGIN COHEN, SULLIVAN & CROMWELL
n 1982, E. Gerald Corrigan wrote “Are Banks physically separated from other companies, even other Special?,”1 a truly seminal article on bank financial companies? This Banking Perspectives article regulation. He then revisited this subject in a examines each of these issues in the context of today’s briefer 2000 article, appropriately entitled “Are regulatory environment and with the benefit of 17 years Banks Special? A Revisitation.”2 Now is the time of additional experience. Ifor a re-revisitation of this work, both because so much has occurred in the financial services industry during BANK REGULATION the ensuing 17 years and as a tribute to Corrigan’s crucial As a result of the unique functions that make banks role in shaping our regulatory structure.3 “special,” a wide-reaching legislative and regulatory structure has been developed to ensure the continued The fundamental conclusion that Corrigan reached availability of these functions. This structure includes the – that banks are special – is still true today. As he following: (1) a comprehensive scheme of bank regulatory emphasized, banks are special because they perform requirements (e.g., capital, liquidity, and stress tests) and unique and indispensable functions in the nation’s restrictions (e.g., powers and loans to affiliates), which are economy; there is, in his words, “a long-standing designed to promote bank resilience; and (2) government consensus that banking functions are essential to a programs of support (principally, federal deposit insurance healthy economy.” and Reserve Bank credit facilities), which are designed to enable banks to incur the risks inherent in their role in the The original article cites, and the subsequent economy. As Corrigan stressed, the predominant objective article endorses, three distinguishing functions that of this special legislative and regulatory structure is the banks perform: transaction accounts (which “permit safety and soundness of individual banks and the banking our diverse economic and financial system to work system. The phrase “safety and soundness” appears at least with relative ease and efficiency”); backup source of five times in the original article. liquidity for all other companies (for which “all other financial markets and all other classes of institutions are At the same time, however, Corrigan recognized the dependent”); and the transmission belt for monetary need for the regulatory structure to be carefully calibrated policy. Moreover, only banks perform the dual functions so that banks are not so constrained as to limit their of both offering transaction accounts (as well as other capacity to fulfill their functions. As he wrote: “[I]f banks short-term deposits and liabilities) and then engaging are special it would not be in the public interest for the in maturity transformation by utilizing those funds to features or functions that make banks special to be eroded provide longer-term loans to consumers, businesses of by competitive, regulatory or legislative forces.” Corrigan’s all sizes, and other organizations (which the original concern persists today. Rigidity or undue stringency in the article describes as “‘term structure’ risk”). Corrigan bank regulatory system can prevent prudent risk-taking posits that, ultimately, “it is the relationship among and create increased costs and friction that drive financial [these functions] that best captures the essence of what services to less-regulated providers – what is known today makes banks special.” as the shadow banking system – that are less capable of dealing with financial or economic stress. Corrigan’s articles also discuss two fundamental questions raised by banks’ special position. First, should Unchanged since 1982 or 2000 are the functions they be regulated differently than other companies, performed by banks that make them special and the even other financial companies? Second, should they be special regulatory structure for banks designed to achieve
14 BANKING PERSPECTIVES QUARTER 3 2017 UPFRONT
safety and soundness. In terms of functions, banks personnel and technology. A more significant element continue to perform their unique roles of creating maturity of cost is the enforcement actions and fines imposed on transformation, providing transaction accounts, and banks that are deemed by examiners to have failed to serving as backup sources of liquidity for the economy. adopt and implement effective anti-money laundering Banks also acted as critical conveyors for monetary policy programs. These penalties are not reserved just for during the 2008 financial crisis, although the magnitude of actual money laundering events but include so-called the crisis demonstrated the limits of monetary policy. “program violations,” even though there are not clear and comprehensive regulatory guidelines and regulators’ In terms of continuing special regulation, the numerous expectations are constantly evolving. bank failures and near failures during the financial crisis, including some of the country’s largest banks, resulted Perhaps the most serious cost relates to resultant in a considerably more stringent regulatory regime. That limitations, indeed prohibitions, on expansion, growth, regime was a function of both “enhanced prudential and structure. Banking organizations that are subject supervision” under the Dodd-Frank Act (including higher to enforcement actions relating to money laundering capital and liquidity requirements, stress tests, living violations are typically disqualified from engaging in new wills, and total loss absorbency capacity requirements) activities, acquisitions, certain investments, or any other and, perhaps even more so, a more rigorous supervisory transaction requiring regulatory approval, even if the approach. It is noteworthy, however, that some of the transaction would promote safety and soundness through most consequential failures and near failures during the greater efficiency, reduced complexity, diversification, or crisis did not involve banks but other financial services otherwise. The prohibitions include both large and small companies, including an insurance company (AIG), two acquisitions, and even internal reorganizations and de investment banks (Lehman and Bear Stearns), and a novo branches. The disqualification period can last for money market fund (Reserve Fund).4 years, as the bank must demonstrate not only remediation but “sustainability” over multiple examinations. What has changed since 2000 is the evolution of the H. RODGIN COHEN enforcement approach to certain long-standing bank A second societal goal is the protection of consumers. H. Rodgin Cohen is a partner at Sullivan & Cromwell. He requirements that are basically unrelated to safety Again, this is a laudable objective, which applies was Chairman of the firm and soundness. This enforcement approach makes to virtually all commercial enterprises, and banks from 2000, through 2009, banks special in a different way, by singling them out undoubtedly have an obligation to comply with consumer and has served as Senior Chairman since 2010. to accomplish certain societal goals and to impose protection laws and, more broadly, to serve the interests of The focus of his practice 5 substantial penalties for failure. However laudable these their customers and communities. Moreover, banks that is regulatory, compliance, societal goals may be, the severity of this enforcement fail to comply should be subject to appropriate penalties, acquisition, enforcement, cyber, and securities law approach does not advance safety and soundness, and although the enforcement of these laws should take into matters for banks, financial sometimes may actually prove counterproductive. account the vast array of consumer compliance laws and institutions, and their trade the evolution of not only regulatory expectations but associations. He works with all the bank regulatory One principal societal goal is a policing function to interpretations. Nonetheless, what is special for banks, as agencies, as well as detect and prevent money laundering and the underlying opposed to other companies, is an enforcement approach multiple other governmental criminal activity, including terrorist financing. The that directly impinges on a bank’s overall business strategy agencies, on behalf of cost to the banking industry for assuming this policing by imposing the widespread disqualifications discussed financial institutions and trade associations, role, which is unique in the private sector, extends in the preceding paragraph. Of course, this has at most a including TCH. well beyond the substantial expense of the requisite tangential relationship to safety and soundness.
BANKING PERSPECTIVES QUARTER 3 2017 15 ArticleMy Perspective Title Goes Here
The divorce between these new companies. By the time of the revisitation Gramm-Leach-Bliley contributed in any enforcement policies and safety and article, however, the Gramm-Leach-Bliley meaningful way to that crisis. This echoes the soundness considerations is illustrated by the Act had removed most of the barriers to the informed economic analyses of the Glass- ratings methodology used by the regulators affiliation of banks and financial companies, Steagall Act itself, where there is no evidence to prohibit expansion, among other things. while preserving the fundamental dichotomy that securities activities of banks or their For decades, banking organizations have between banking and commerce. affiliates were a meaningful contributor to the been rated under the so-called CAMELS collapse of the banking system at the onset of rating system. The components of this Corrigan concluded in 2000 that “to a the Great Depression. system relate to safety and soundness: C = very considerable degree, GLB seems to capital adequacy; A = asset quality; M = acknowledge that banks are special. Indeed, CONCLUSION management; E = earnings; L = liquidity; the Act is both powerful and progressive in Banks are special, as Corrigan persuasively and S = sensitivity to risk.6 A management or providing a coherent framework to guide the argued, because of the unique and fundamental capital rating, or a composite rating across the next phase of the evolution of banking and role they play in supporting the nation’s six components, of “unsatisfactory” (“3”) or finance in the United States.” In particular, economy. For this reason, the scope of below precludes expansion.7 the act preserved the bank holding company regulation of both banks and their affiliates must model favored by Corrigan by limiting the carefully balance the need for robust safety and Notably, there is no component in the conduct of the new financial services activities soundness standards with the need for sufficient CAMELS system for compliance with to the holding company. flexibility so that banks are capable of fulfilling regulations unrelated to safety and soundness. that role, which requires carefully calibrated This is logical because, except in egregious With one major exception, the Dodd-Frank risk-taking. As Corrigan aptly concluded, this circumstances, failures with respect to such Act maintained the basic structure for bank balance is crucial so that, given banks’ special regulations would not detract meaningfully affiliations that existed after Gramm-Leach- role, they must be able to “maintain profitability, from safety and soundness. Nonetheless, Bliley. That exception was the Volcker Rule’s attract capital and preserve a de facto monopoly the bank regulatory agencies have, in effect, partial rollback of Gramm-Leach-Bliley’s on the transaction account business.” n not only made compliance a component partial repeal of the Glass-Steagall Act. of the CAMELS rating system but an often Gramm-Leach-Bliley had removed Glass- ENDNOTES determinative component. Typically, any Steagall’s “not engaged principally” limitation 1 Available on the website of the Federal Reserve significant compliance failure is now on investment banking by affiliates of banks Bank of Minneapolis: https://www.minneapolisfed. org/publications/annual-reports/are-banks-special deemed by the regulators to reduce the (Section 20). The Volcker Rule eliminated the 2 Available on the website of the Federal Reserve management (M) rating to “unsatisfactory,” authority of bank affiliates, as well as banks Bank of Minneapolis: https://www.minneapolisfed. and, as indicated, such a rating precludes a themselves, to engage in proprietary trading org/publications/the-region/are-banks-special broad range of activities and transactions. and investments in covered funds. 3 Corrigan served as the President of the Federal This result is different from the safety and Reserve Banks of Minneapolis and New York, and also as the closest approximation of an “eighth” soundness regulatory regime envisioned More recent calls for a return to Glass- Federal Reserve Board Governor. in Corrigan’s articles. It remains to be seen Steagall have not been couched in terms of 4 The Dodd-Frank Act did include a provision to whether the Federal Reserve’s proposed new preserving the special nature of banks. Indeed, subject “systemic” non-bank financial companies to special supervision. rating system for large banking organizations such an argument could not legitimately be 5 The imposition of this much more stringent will change that result. made because the Gramm-Leach-Bliley Act enforcement regime coincides, at least in time, with left untouched the Glass-Steagall restrictions a sharp decline in the public perception of banks BANK AFFILIATIONS on the operations of banks themselves. Of following the 2008 financial crisis. In Corrigan’s original article, a central thesis even more importance, these proposals are not 6 The Federal Reserve has recently proposed a new rating system for large bank holding companies. was that the special position of banks made grounded in an analysis of the 2008 financial 7 Likewise, a Community Reinvestment Act rating of it injudicious for them to affiliate with other crisis, because no evidence has been adduced “needs to improve” or below is generally preclusive companies, including most other financial that the partial repeal of Glass-Steagall in of expansion.
16 BANKING PERSPECTIVES QUARTER 3 2017 © 2017 Ernst & Young LLP. All Rights Reserved. ED None.
Cybercrime can only be fought by combining technology combining by only be fought can Cybercrime to cybercrime to technology, more people? or more with uniquely human insights. acumen and business #BetterQuestions ey.com/betterworkingworld Is the answer Is the State of Banking
Much of the regulation that came out of Dodd- Frank made for a stronger financial services sector. The need and the requirement to stress-test our portfolios make a lot of sense.... But Dodd-Frank has also created some unnecessary complexities, especially around lending.
STATE OF BANKING 18 BANKING PERSPECTIVES QUARTER 3 2017 State of Banking UPFRONT
Greg Carmichael, CEO of Fifth Third Bancorp, discusses the effect of regulations on the industry, the relationship between FinTechs and banks, and his thoughts about the future with Jim Aramanda, President and CEO of The Clearing House.
JIM ARAMANDA, TCH: You have a deep background First, there’s never just the right amount of regulation. in technology, including as a CIO. And you have made In any amount, regulation will prevent some positive technology an important part of Fifth Third’s growth innovations that would help customers. Likewise, even strategy. Could you provide us with your perspective, the most stringent regulation will fail to catch some particularly as someone with a technology background, innovations that don’t create value and that weaken the on how you are using technology to grow revenue, manage stability of our financial systems. Ultimately, it’s about expenses, and provide new products and services to balance, and that balance has to be found in each area, your customers? Also, I’d welcome your views on how each business and each regulation. Understandably, technological innovation and regulation intersect – for we are not pleased about regulations that prevent us instance, is it challenging for banks to effectively innovate from pursuing innovation that would enable better due to their regulated nature? outcomes for customers. We strongly believe that some regulations should be changed to enable better GREG CARMICHAEL, FIFTH THIRD BANCORP: First, outcomes for our customers, without risking safety let me share a couple of general comments on innovation or soundness. At the same time, we recognize and and Project NorthStar, an initiative we launched last year. appreciate the very important role that regulations play The overall strategic approach is really about putting the in protecting customers and ensuring the safety and customer at the center of everything we do. It focuses on soundness of the financial system. We appreciate the taking care of the customer, as well as growing revenue ongoing dialogue we have with regulators on how best and managing expenses, as you mentioned. to achieve this balance.
Cutting costs just to cut costs, which could hurt When we put new products or services into the our ability to serve our customers, is not acceptable. market, we should have an opportunity to learn from Project NorthStar puts the emphasis on being the customer experience and the ability to modify that customer-centered in all things. product appropriately. Currently, we are operating in a zero-tolerance regulatory environment. With respect to the question of whether regulation has the effect of holding back banks from creating This environment presents challenges to introducing new products or offerings, here’s what I would tell you. technologies, products, or services. If we have an issue, STATE OF BANKING BANKING PERSPECTIVES QUARTER 3 2017 19 State of Banking
we can’t advance the products or services. A zero- important. But under Dodd-Frank and under CCAR tolerance regulatory environment puts constraints analysis, because of the nature of a small business loan, on products and services that we may like to get into typically most of those are leveraged loans and we get the marketplace. For instance, small dollar lending penalized. We have to hold more capital for a small has been problematic. As you know, Jim, small-dollar business loan than you do for a consumer loan. lending is a very important product for our customers. Many customers are regularly going out to payday When you look at the amount of capital you have to lenders, title loans, and pawn shops to get short-term hold, and the underwriting requirements for a small access to dollars. business loan versus a larger loan, the cost is the same. It makes it more difficult to serve small businesses, We also know that a significant amount of the and you see small business lending by banks being American population lives paycheck-to-paycheck, and significantly reduced over what you saw pre-crisis. nearly half of the population can’t cover an unexpected $400 expense. So, there’s a real need for temporary Once again, a lot of regulation that came out of Dodd- emergency funds to cover situations such as a car Frank made for a stronger financial services sector. The breaking down, a refrigerator going out, a roof leaking, requirement to stress-test our portfolios makes a lot of or something of that nature. sense. We should continue to do that.
It’s important we get a banking product out to serve this But Dodd-Frank has also created some complexities need, and we appreciate that regulators are rightly focused around lending. Likewise, the cost associated with on protecting consumers from potentially unscrupulous compliance, such as DFAST and CCAR, forces resources lenders. But the guidelines issued to date will prohibit to be pulled away from new product introduction. banks from offering a suitable product. ARAMANDA: Yes. I think the other TCH member bank With a limited amount of resources that a bank has CEOs would agree with you and the way you characterize to apply to new products, and the limited amount of it. While a lot of it makes sense, Dodd-Frank needs to value that a product of that nature creates for the bank be recalibrated. Its impact on the industry and on the itself – but a huge value for the customer – we can’t economy also needs to be considered as well. implement a product that needs to meet significant hurdles to satisfy regulators. The solutions should CARMICHAEL: Agreed. be simple, efficient, inexpensive and effective for the customers. With overly restrictive rules, it takes ARAMANDA: You are one of the select few CIOs who as long and as much effort and cost to originate a have gone on to become a CEO of a financial company. $500 loan as it does a $1 million loan. Those types How do you think your background gives you an of constraints just impede our ability to introduce advantage when it comes to running a bank? the right types of products and services to our customers. Instead, these limitations end up leaving CARMICHAEL: Jim, I’ve spent my entire career using the marketplace in the hands of the payday lenders or technology in a way to solve business problems or to emerging FinTech start-ups. make a company more efficient. When you think about the skills associated with putting in new technology, Another example is small business loans. We know the preparation, the testing, the disaster planning you that small businesses are the primary source of job have to go through to make sure you can recover from a formation in the economy. They create two out of every situation, all of those skills are very helpful when you sit three new jobs. Small business loans are thus extremely as a CEO of any company.
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Our fintech strategy great opportunity. We embrace FinTechs as partners who can help make us better. We have FinTech in our DNA plus allows us to accelerate more than 150 years of financial services experience. In the pace at which we bring fact, Fifth Third has a long heritage in the FinTech space. We’ve been doing FinTech integration and partnerships new and better products, for the last decade at Fifth Third to introduce new services, and experiences products and services. Examples include bill pay, mobile to our customers. banking, payment solutions, etc. Fifth Third was the first bank to introduce a network ATM infrastructure back in the late ’70s. We’ve been In our sector right now, what’s really interesting is the pace innovative for a long time. We built Vantiv Corporation, of change we’re experiencing, driven by digital capabilities. which is now a very large FinTech company. All in all, The digital capabilities have been enabled by some of the I look at FinTech as an opportunity to better serve our legislation that’s been passed in the past few decades. Check customers and to differentiate ourselves. FinTech is not 21 enabled banks to transact with a digital image of a check something that I view as a threat. versus the physical check. The new legislation plus the emergence of broadband internet, smartphone technology, ARAMANDA: Yes, I think FinTechs are a threat if you and web-based applications all came together to change don’t understand what they can do to help drive solutions how we serve our customers, the products we offer, and the to the market. While we’re on that topic, can you talk channels in which we can offer those products. about Fifth Third’s partnership with private equity?
A technology background is very helpful with CARMICHAEL: Absolutely. We are extremely excited the digital transformation that’s occurring now. My and proud of our partnership with QED Investors. QED approach to problem solving and using technology adds is a small boutique private equity firm focused on the to how I look at my job as CEO. FinTech space. It’s a great company with tremendous leadership. QED takes a hands-on approach to its My technology experience is very helpful in my current investments premised on deep operational experience role as we work to assess the right type of technology or in financial services. They work with over 50 different the right type of partnerships. FinTech entities in startup phase. Our partnership with QED enables Fifth Third to get the first look at those We have a clear strategy at Fifth Third when it comes businesses and determine if there’s an opportunity for to technology: buy, partner, then build. That mentality us to invest directly, partner, or, in some cases, acquire of looking out and finding the best partners and the those entities at an early stage. best solutions to solve our problems and implement them quicker, in this day and age, gives a bank an This partnership has already helped us form advantage. This strategy is driven by the way our relationships with companies like GreenSky, ApplePie customers want to bank, which is anywhere, anytime. Capital, Transactis, and AvidXchange. This has enabled They want simple, easy and fast banking services for Fifth Third to accelerate our innovation in those different day-to-day transactions, and they want a relationship areas, whether it is unsecured lending, small business with a trusted advisor. franchise lending, or accounts payable automation.
And to finish answering your question, I’d like to also Working with QED accelerates our ability to evaluate discuss FinTechs. You know, Jim, I look at FinTechs as a FinTech companies, and then, where appropriate, make
22 BANKING PERSPECTIVES QUARTER 3 2017 State of Banking
In an increasingly regulated world, we have an exceptionalIn an increasingly ability to helpregulated clients world, navigate we have their an most exceptionalcomplex business ability to problems, help clients deals, navigate and disputes. their most complex business problems, deals, and disputes. Our financial institutions practice—with its team of former government officials—is recognized as a leaderOur financial in the field. institutions Clients aroundpractice—with the world its turnteam to of usformer for advice government on a broad officials—is array of legal recognized issues, and as a withleader our in distinctivelythe field. Clients collaborative around the culture, world we turn work to togetherus for advice to create on a broadinnovative array solutionsof legal issues, to their and toughestwith our problems.distinctively collaborative culture, we work together to create innovative solutions to their toughest problems.
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© 2017 Covington & Burling LLP. All rights reserved. State of Banking
an investment that creates a strategic relationship. And, aware and concerned about this, and my hope is that most important, our FinTech strategy, of which QED the regulators will evaluate these FinTech companies in is an critical part, allows us to accelerate the pace at the same manner in which they evaluate and regulate which we bring new and better products, services and Fifth Third Bank. experiences to our customers. We know how to compete in this environment, and ARAMANDA: Do you have any concerns about the we desire what I’ll call a level regulatory playing field FinTech industry and products and services they offer? For for all participants. instance, do you have concerns over potential liabilities it may create for Fifth Third or your customers? Also, what ARAMANDA: As you mentioned earlier, it’s important kind of touch do you think the regulators should have on to partner with a FinTech to make sure safety and the FinTech market? soundness is addressed. If banks don’t do that, these newer companies will go out and build products that tend to disintermediate banks from their customers, and the A technology background banks may risk becoming a utility. is very helpful with the digital CARMICHAEL: Well, the interesting thing with transformation that’s occuring now. FinTechs is that most of them need a bank as a partner My approach to problem solving to be successful. and using technology adds to GreenSky doesn’t exist, Lending Club doesn’t exist, how I look at my job as a CEO. OnDeck doesn’t exist without liquidity and the safe harbor banks provide for the asset. Partnerships between a bank and a FinTechs are a potential strong win for our customers and a win for our banking shareholders CARMICHAEL: Yes, I think the regulators should because we’re more efficient in how we deliver innovative be involved. Banks are held accountable to protect products and services. our customers and make sure that there’s safety and soundness in what the banks are doing. The regulators ARAMANDA: Well said. Moving on to the next topic, need to balance the need for customer protection and the banking industry, as we all know, over the last eight systemic safety and soundness on the one hand with or nine years has undergone more regulatory change innovation and customer value on the other. They than any time in the history of banking. With a new need to create an environment that provides the same administration in the White House, there’s plenty of talk safeguards in the FinTech space that banks have to of regulatory reform. What areas of the bank regulatory adhere to when introducing new products and services framework do you think need to be recalibrated? to customers. CARMICHAEL: I think it’s appropriate to revisit certain I am concerned about emerging entities that do a lot aspects of Dodd-Frank, especially when you think of screen-scraping, which puts pressure on our networks about the traditional regional banks like Fifth Third. and our systems to support their business. There’s an opportunity to more appropriately tailor prudential standards by tying the type of business that And, of course, there is the customer service aspect. a traditional regional bank has to the systemic risk it When customers have an issue or a problem, they don’t poses to the financial services sector, rather than the contact the FinTech company, they go to the bank. I’m single measurement of asset size.
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© 2017 Morrison & Foerster LLP State of Banking
Fifth Third and most of its regional peers are not our Private Bank, it creates a very different relationship Wall Street banks. We’re Main Street banks. We’re more because we’re focused on long-term financial wealth similar to large community banks with a bigger balance creation, retirement planning services, and how to sheet, but we do not do a lot of the types of high-risk protect their wealth over time. transactions or have the international exposure that many trillionaire banks have. We become their strategic wealth partner, and that creates a different bond with those customers. In addition There’s an opportunity to tailor Dodd-Frank more to that, Jim, as you know, the population is aging and appropriately to the risk that banks create for the unprecedented numbers are approaching retirement. financial services sector. That will allow us to do a People are very concerned about having enough financial better job of serving our customers, quite frankly, and resources to be financially successful through retirement. deploying our capital more strategically, while reducing We want to be there to help them do that. our cost to serve customers. That’s why we acquired a company called Retirement Regulation should be tailored based on business factors, Corporation of America and we’re investing heavily into such as interconnectivity, global activity, and complexity. our insurance capabilities. Our wealth planning platform, All those things should be considered when you think called Life 360, is a secure and convenient web-based about the risk a bank or a financial services entity creates platform that specifically meets the complex needs of our for the financial services sector. There is certainly an Private Bank customers. It provides a digitally integrated opportunity to right-size some aspects of regulation. view of all a customer’s assets across all of their financial relationships, whether they are at Fifth Third or at another ARAMANDA: Yes. And I think there’s the appetite in financial institution. Life 360 includes an electronic Washington to do that. “vault” storage feature that is an outstanding platform to save and share important documents with family CARMICHAEL: There is a need to revisit some of the members or financial managers. It also allows customers regulations and how restrictive they are, and assess to create projections and offers other tools to enable our the applicability of those regulations to where we’re at Private Bank customers to plan better for their future. today. Generally speaking, banks are well capitalized. We are holding significantly more capital than we had Wealth management and insurance have been strong going into the Great Recession. We need to maintain a growth areas over the last five years because of the significant capital position to absorb losses in the event investments that we made. They are very important of an economic downturn. But we also need to be able to services to our customers. deploy some of that capital differently than we have in the past for strategic opportunities. ARAMANDA: What concerns you about what you are seeing in the different markets that Fifth Third services? ARAMANDA: Switching gears, you’ve been expanding in What sectors are still lagging? Are there some that are wealth management and insurance. Can you talk about overheating? And, maybe, what geographic regions would the opportunities you see in those areas and why Fifth you hope should have better growth prospects than they’ve Third is investing in those segments? been experiencing?
CARMICHAEL: Wealth management and insurance CARMICHAEL: As you know, Jim, we’re in the third- are businesses that create a lot of stickiness to the longest economic expansion in the history of the U.S. relationship that we have with our customers. Once Broadly speaking, one of the concerns I have is that the you become their wealth partner, and they’re part of length of the recovery suggests that we’re in the latter
26 BANKING PERSPECTIVES QUARTER 3 2017 State of Banking
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innings, potentially, of the cycle. That’s something we’re footprint, which extends from the Midwest down to the very mindful of going forward. Southeast, has a very diverse mix of businesses in both manufacturing, technology, and the service industry. GDP growth remains slow. I think the latest reading We’re very similar to the rest of the United States with was around 1.2% annualized. There’s also a lot of respect to the type of companies that we bank across our concern and lack of clarity around the timing and footprint. We’re not heavily concentrated in any one area. magnitude of reforms, which creates headwinds for our business. Are we going to get corporate tax reform? Are ARAMANDA: Looking ahead, do you see any fundamental we going to see a different healthcare structure put in shifts taking place that will affect the overall economy in the place and the repeal of Obamacare? Are we going to get years to come? fiscal stimulus in the form of infrastructure investments, defense investments, which would bode well for a lot of CARMICHAEL: I think there’s a lot. It’s difficult to say our customers? Are we going to see that materialize this five years from now what the economy is going to look year? We don’t know that, and nor do our customers. like, to be honest with you.
That creates some challenges from a growth perspective There are concerns around the administration’s and for companies to make decisions. If you’re going to ability to introduce their policies and get them into sell your company or acquire a company, you may be more production, so to speak, whether tax reform, fiscal attracted to a 20% tax structure than a 35% tax structure. stimulus, or healthcare reform. I don’t know how So it may impact your decision making. That’s just reality. they’re going to play out.
On the positive side, I would tell you credit losses are I think those will have far-reaching consequences. If we at an all-time low for most banks right now. For Fifth don’t get corporate tax reform, I think that’s going to be a Third, our credit losses are below pre-crisis levels. Our setback. If we don’t see some type of regulatory relief for forward metrics are very positive and strong. Credit corporations, especially financial services, I think we’re continues to be a positive in the current cycle, but once going to continue to be challenged to grow. While there are again, we’re in the latter end of the cycle. concerns, we are focused on the things we can control and what we can do to better serve our customers. To answer your question about areas/sectors that are lagging, I would tell you we’re seeing the same thing ARAMANDA: Finally, can you speak about Fifth Third’s that you are seeing. From a sector perspective, we see community commitment? broader weakness in the brick-and-mortar retail space for traditional clothing and the electronic retailers. CARMICHAEL: With pleasure, Jim. Fifth Third That should be no surprise as they’re getting pressure has always been a strong contributor to all the from companies like Amazon or eBay, and they really communities in which we serve. I am a firm believer have to rethink their business model. that you can’t build a strong bank without having strong communities. We’re very, very focused on In addition, the energy sector has rebounded a little serving our communities, and are making that off its lows in February 2016, but not where it was nor is commitment more visible with respect to how much it in a healthy state. We don’t have a large exposure there, we are doing to help them be successful. but it’s one we watch carefully. In November 2016, we announced a $30 billion, five- From a geographical perspective, we have seen fairly year community development plan over 10 states where balanced growth within our footprint. We believe that our we have a retail banking presence. This is the largest
28 BANKING PERSPECTIVES QUARTER 3 2017 State of Banking UPFRONT
community development plan made by a single regional bank in recent history. We partnered with the National Community Reinvestment Coalition (NCRC), to make sure that we’re doing the right things to create the greatest value in each community we serve. The NCRC is working with over 145 member organizations, and has been a tremendous partner to Fifth Third Bank.
Our $30 billion community commitment focuses on supporting low- to moderate-income borrowers. $11 billion of our five-year commitment is dedicated to mortgage lending; $10 billion is for small business lending; and $9 billion is for community development lending and investments.
We also are committing almost $155 million over five years in philanthropic investments, housing-related investments, small business-related investments, branch and staffing commitments in low- to moderate-income areas, inclusion and diversity and financial literacy.
The NCRC’s President and CEO John Taylor has been a great partner to Fifth Third. In our joint press conference, he declared that “Banks are our neighborhoods’ best hope” and I could not agree more. Our commitment has been well received, and I think it’s really helping the communities see that banks are, indeed, their best hope. We have to stand behind those words by the actions that we’re taking and the investments that we’re making. We’re now in year two of this commitment. In year one, we delivered $7.8 billion. This includes $3.2 billion in mortgage lending, $1.6 billion in small business lending, $2.6 billion in community development lending, and $19 million in philanthropic donations. This represents 26% of the total commitment. I believe that we’ll exceed our overall commitment over the next years, and I could not be more proud of the contribution we are making to our communities. It feels just right and it feels good.
ARAMANDA: Greg, thank you for your time. n
BANKING PERSPECTIVES QUARTER 3 2017 29 FINANCIAL REGULATIONS SHOULD NOT PROTECT PEOPLE FROM BUSINESS OR FINANCIAL RISK THAT THEY KNOWINGLY CHOOSE TO ACCEPT. REFORM SHOULD START FROM THIS PRINCIPLE: FIRMS THAT ABSORB MORE OF THEIR OWN LOSSES DO NOT NEED TO BE HEAVILY REGULATED.
BY NORBERT MICHEL THE HERITAGE FOUNDATION
30 BANKING PERSPECTIVES QUARTER 3 2017 FOR AT LEAST A CENTURY, the U.S. regulatory framework has increasingly hindered the financial intermediation process, particularly in the banking industry. The current regulatory regime is counterproductive for many reasons, including the fact that there are too many regulators with redundant authority. Unlike non-financial companies, banks endure countless activity restrictions that substitute regulators’ judgments for those of owners and managers. These restrictions are justified as necessary to protect taxpayers, but they undermine that purpose by creating a false sense of security and increasing moral hazard.
These restrictions thus feed into a self-reinforcing taxpayer backing of financial losses, making it possible cycle in which policymakers expand the scope of losses for private citizens to build a stronger financial system that U.S. taxpayers absorb as well as the size and scope that efficiently directs capital to its most-valued uses. of restrictions that banks face. Fixing this framework This article provides an overview of where banking requires rolling back both government regulations and regulation has gone wrong, what a better approach F BANKING PERSPECTIVES QUARTER 3 2017 31 Structural Limitations and Activity Restrictions
would look like, and what type of reforms are most frameworks raises serious doubt about how much faith likely to occur in the near future. people should place in the new rules.
RECENT REGULATORY CHANGES SHOULD In 2007, New York Federal Reserve President Timothy NOT BOLSTER CONFIDENCE Geithner praised “the depth and liquidity of our world- History provides more than enough evidence that class financial markets and a record of stability in policymakers have been playing a whack-a-mole macroeconomic policy.”4 He also praised global regulators game with bank safety and soundness. As government and noted, “Financial markets outside the United interventions – particularly central banking, deposit States are now deeper and more liquid than they used insurance, and loan guarantees – became more to be, making it easier for companies to raise capital widespread internationally, banking crises have occurred domestically at reasonable cost.”5 In hindsight, Geithner relatively more frequently.1 Perhaps surprisingly, the U.S. surely held a different view, but his speech is eerily similar has had one of the worst experiences, with 15 banking to the 1984 congressional testimony of Comptroller Todd crises since 1837.2 This total ranks among the highest of Conover.6 In both cases, a high-ranking federal regulator all developed countries, and the U.S. is one of only three effectively assured the public that the financial system developed nations that experienced at least two banking was on solid footing due to stronger capital. On page 219 crises between 1970 and 2010.3 While the Federal Reserve of the committee report, Conover appeals directly to the was created (in 1913) specifically to stem crises and the benefits of higher capital requirements: resulting spillovers to the broader economy, it has clearly failed to fulfill that promise. Under regulations proposed by the OCC and the FDIC, all banks, regardless of size, would be required to maintain a minimum ratio of primary capital to Though many pundits blame previous total assets of 5.5 percent. The implementation of this crises on deregulation and a lack of regulation will require over 200 national banks to raise a total of over $5 billion in new capital. The Federal rules, banks have been subject to extensive Reserve has proposed similar guidelines on capital. restrictions on their activities, capital, Stricter regulatory capital requirements will and asset composition for decades. strengthen the trend towards stronger capitalization of the nation’s largest banks. For example, in the first quarter of 1984 the average ratio of primary capital to total assets stood at 5.67 percent for the holding Multiple U.S. financial regulators implemented companies of the 11 multinational banks supervised stringent regulations and price controls in response to the by the OCC. This is almost 16 percent higher than the Great Depression, but these rules imploded when high average level at those banks two years ago. inflation exposed their weaknesses in the 1970s. After the Basel I rules were implemented in the late 1980s, There is no doubt that higher equity funding enables regulators developed their supposedly superior version, banks to better absorb losses, if all else remains constant. the Basel II rules. While these new rules were being But even without the caveat, it does not follow that forcing implemented in several countries, the 2008 financial banks to meet higher equity ratios is a good policy solution crisis hit, causing regulators to get to work on Basel for improving safety and soundness. Regulatory capital III before Basel II could be fully implemented. Now, requirements are arbitrarily designed based on losses in regulators are finalizing the Basel III rules and making the previous financial crises, and their engineers simply cannot same promises as before – that banks are now safer and know for certain what problems will unfold in the future or stronger because of the new rules. Even a cursory look how large losses will be. Proponents of the latest round of at what regulators said prior to the implosion of earlier Basel rules and the systemic regulations in the Dodd-Frank
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Rather than focusing on providing rating, but it converted to a CAMELS rating, where the “S” stood for “sensitivity to market risk.”10 It may be customers with the best possible comforting to think that the new rules will keep banks service, banks have to worry about safe and avoid future crises, but history suggests such satisfying sociopolitical goals, even when hopes should be tempered. pursuing such policies conflicts Though many pundits blame previous crises on with sound banking practices. deregulation and a lack of rules, banks have been subject to extensive restrictions on their activities, capital, and asset composition for decades. Most often, these rules and regulations have created bad incentives and resulted Act insist that this time will be different, because now the in unintended consequences. Glass-Steagall restrictions, rules are focused on systemic problems, whereas previously price controls, and stringent rules on real estate lending they were concerned with individual banks. This concept have all weakened banks’ balance sheets in the past, has been grossly oversold, as systemic problems were sometimes severely so. The risk-weighted Basel capital contemplated by previous iterations of the Basel rules. requirements are the latest example of such failures: regulators required lower capital charges against assets Indeed, the subheading of Conover’s 1984 testimony was they blessed as safe, thus biasing the banking system “The Supervisor’s Role is to Maintain Systemic Soundness.” toward more uniform balance sheets filled with those He also provided the following specific examples: assets. In hindsight, of course, those risk assessments were wrong, and many banks held large amounts of what Our supervision of banks of all sizes has been turned out to be very risky assets. enhanced by the establishment of an Industry Review Program. This program includes a computerized For the most part, the new macro-prudential tools are information system to collect data on industry nothing more than reworked versions of the same old concentrations in individual bank portfolios and the liquidity and capital requirements. Though some of these banking system as a whole.7 tools are not as risk-based, they give regulators discretion to add extra layers of capital as they deem necessary. In addition to the more frequent examinations we This approach is highly flawed for the same reasons that have undertaken, the examiners will also monitor the earlier framework was defective. It assumes that trends and developments in the banks between regulators can design and mandate a safe financial system examinations. This new approach results in near- where banks still take financial risks, and it ignores constant supervision of each of our large banks. that market participants have much stronger incentives – a profit-loss motive – than regulators to discipline We are now better able to identify and devote inefficient and overly risky firms. Nonetheless, rules have attention to items of supervisory concern in individual continued to grow in number and complexity based on large banks and significant practices emerging in the the notion that they will prevent systemic crises. large bank population as a whole.8 A SAMPLE OF EXISTING REGULATIONS Conover’s testimony is far from an isolated incident. AND RESTRICTIONS For instance, systemic-risk concerns were discussed by a Banks’ activities are highly regulated by both state and Fed Governor’s testimony before the House Subcommittee federal regulators, more so than most types of businesses. on Economic Stabilization in 1991, just after the Basel I They face restrictions on capital, liquidity, mergers, accords were implemented.9 In 1996, the Fed explicitly acquisitions, and earnings distributions, among other accounted for system-wide risk in its bank supervisory activities. Regulators routinely examine banks’ records to rating system. Prior to the change, the Fed used a CAMEL ensure that they are following the rules, and sometimes
34 BANKING PERSPECTIVES QUARTER 3 2017 use these examinations to implement changes to the rules. apply to banks’ leverage, liquidity, and Banks tend to comply even with regulators’ informal capital requirements, as well as overall risk suggestions because failure to do so can bring additional management and resolution processes. regulatory scrutiny or formal enforcement actions, and there is essentially no appeals process for this type of • Federal regulators now impose a wide array of regulation by supervision. risk-weighted minimum capital requirements, as well a liquidity coverage ratio, a net stable Policymakers generally justify this extensive system of funding ratio, a supplementary leverage ratio, regulation as necessary to protect taxpayers, particularly and a wide array of monitoring tools designed from losses to the federal deposit insurance fund, but no to monitor banks’ liquidity and risk profiles. part of the framework is ideal. This approach, though well intentioned, has demonstrably failed and has given rise • The Federal Reserve, as the primary regulator to the too-big-to-fail problem. It also provides the public of all bank holding companies, regulates with a false sense of security because the government the “financial condition and operations, confers an aura of safety (during normal conditions) on management, and intercompany relationships all firms that play by the rules, and it prevents banks from of the bank holding company and its evolving to meet the changing needs of customers. subsidiaries, and related matters.”11
This regulatory approach is bound to fail for at least three • Federal law limits how much money a bank reasons: (1) People take on more risk than they would in the can lend to any one customer or to a group of absence of such rules; (2) people have lower incentives to related customers, and banks are subject to monitor financial risks than they would otherwise; and (3) lending limits (and other restrictions) on loans compared to other actors in the market, regulators do not they can provide to insiders (such as officers, have superior knowledge of future risks. The logic driving directors, and certain significant shareholders), this system – protecting people from the consequences of as well as to affiliate institutions. financial decisions – also creates an ever-expanding need for more government rules to replace market competition. • Regulation E covers rules for electronic Banks are now highly regulated and severely limited in the funds transfers, Regulation C covers home types of financial intermediation they can provide, thus mortgage disclosure rules, and Regulation Z further weakening the financial system. (Truth in Lending) prescribes uniform rules for “computing the cost of credit, for disclosing In practice, as Congress and regulators expand the rules, credit terms, and for resolving errors on certain banks end up in roles for which they are ill suited, such as types of credit accounts.”12 policing money launderers and pursuing affordable housing goals. Rather than focusing on providing customers with • Regulation BB implements the Community the best possible service at the best possible price, banks Reinvestment Act (CRA), a law that Congress have to worry about satisfying sociopolitical goals, even passed in 1977 because politicians were when pursuing such policies conflicts with sound banking unhappy with banks’ provisioning of credit, practices. For all of these reasons, statutory and regulatory particularly with regard to low-income restrictions now go well beyond simple capital and liquidity neighborhoods. ratios. The following list provides a brief overview: • Banks are subject to the Equal Credit • All bank holding companies with assets Opportunity Act,13 a 1974 law passed to of more than $50 billion are subject to promote adequate disclosure of information heightened supervision by the Fed, as required and to shield protected classes of consumers by the Dodd-Frank Act. These special standards from discrimination when applying for
BANKING PERSPECTIVES QUARTER 3 2017 35 Structural Limitations and Activity Restrictions
credit. The law is now part of the framework been overseen by the OTS, which was eliminated by Dodd- used to prove disparate impact, whereby Frank), securities holding companies, and systemically regulators can prohibit activities because of a important financial institutions. To fix bank regulation and disproportionately negative impact, even in the improve financial intermediation, Congress should reduce absence of intentional discrimination. taxpayer backing of financial losses, pare back restrictions so that banks can expand their activities, and restructure • Banks are required to comply with complex the agencies that write and enforce regulations. anti-money laundering (AML) statutes and regulations, such as “know your customer” THE OVERABUNDANCE OF requirements primarily administered by the REGULATORY AGENCIES Treasury Department’s Financial Crimes The U.S. banking regulatory structure is overly complex, Enforcement Network (FinCEN). These rules with responsibilities fragmented among many different have effectively turned banks into quasi law federal and state regulators. The list of possible regulators enforcement agencies. Federal regulators also at the federal level includes (but is not limited to): (1) require financial institutions to institute formal the Federal Reserve, (2) the Federal Deposit Insurance compliance programs for the AML rules, and Corporation (FDIC), (3) the Securities and Exchange regulators heavily micromanage this process. Commission, (4) the Commodity Futures Trading Commission, (5) the Consumer Financial Protection • Section 619 of the Dodd-Frank Act imposed Bureau, (6) the National Credit Union Administration the Volcker rule, a restriction that prohibits (NCUA), and various agencies within the U.S. Treasury banks from making certain risky investments Department. Besides the Office of the Comptroller of (trades) solely for their own profit, a practice the Currency (OCC), FinCEN and the Internal Revenue known as proprietary trading. This complex Service impose a wide variety of information-reporting rule is one of the clearest examples of a and due-diligence requirements on financial institutions. government regulation that limits the types Furthermore, Title I of Dodd-Frank created the Financial of financial intermediation banks can provide, Stability Oversight Council (FSOC), a council that consists thus further weakening the financial system. of the heads of many of the above-mentioned regulatory agencies, and tasked it with several broad responsibilities, In many of these (and other) cases, banks are subject including developing activity restrictions. to the compliance regimes of more than one federal regulator and even those imposed under state law. Thus, The FDIC has backup supervisory authority over all banks in practice, both state and federally chartered banks are and thrifts that are federally insured, and this responsibility subject to state laws governing the basic transactions in overlaps with supervisory authorities of the Federal Reserve which they engage with their customers. The Uniform and the OCC. The NCUA supervises only federally chartered Commercial Code, for instance, governs (among credit unions, but it is the deposit insurer for both federal other things) transactions in commercial paper and credit unions and most state-chartered credit unions, so promissory notes, bank deposits, funds transfers, secured its authorities overlap with state credit union regulators. transactions, and contracts. While the Dodd-Frank Act The Fed has consolidated supervisory authority over most did not create this problem, it certainly worsened it. holding companies that own or control a bank or thrift and their subsidiaries, so it overlaps with the supervisory Dodd-Frank created a consumer watchdog agency for the authority of banks’ primary federal regulators. financial industry, the CFPB, increased the responsibilities of several federal regulators, and included a new systemic- Coordination among agencies requires considerable risk mandate for the Federal Reserve. Dodd-Frank also gave effort that could be directed toward more productive the Fed supervisory authority over other entities, such as activities, and the multiregulator approach has a long savings-and-loan holding companies (which previously had history of creating inefficiencies and inconsistencies in
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regulatory processes. There simply is no need for so many between regulators that simply does not exist.14 Bank regulators, and the existing framework creates an uncertain regulatory reforms should include major structural changes operating environment for regulated entities and regulators. because there are too many federal banking regulators with Some of the best-known historical examples of these too many overlapping authorities. inefficiencies and inconsistencies include the following: HOW BANK REGULATION SHOULD BE REFORMED Congress should fix the structural problems in the Congress should fix the structural current system by creating one federal banking regulator problems in the current system and one capital markets regulator. This approach would by creating one federal banking regulator improve efficiency and effectiveness while guarding against the dangers of having a single bank-centric and one capital markets regulator. super-regulator. It is critical that this realignment removes This approach would improve the Federal Reserve from financial regulation. As the U.S. central bank, the Federal Reserve’s primary role is efficiency and effectiveness. monetary policy, which dictates that it should focus on providing system-wide liquidity. Allowing the same entity to exercise regulatory and monetary functions gives rise to unnecessary and potentially dangerous conflicts of interest, • Differences in examination scope, frequency, and the Fed’s regulatory and supervisory responsibilities are documentation, guidance, and rules among the simply unnecessary for conducting monetary policy. FDIC, OCC, and the Fed To create the single banking regulator, the OCC, FDIC, • Inconsistent methods for assessing loan loss and NCUA should be merged. Then, the Fed’s regulatory reserves responsibilities would be shifted to this merged entity. Merging the CFTC and the SEC would give the U.S. • Inconsistent guidance and terminology a single capital markets regulator, but other reforms for Bank Secrecy Act examinations and would still be necessary. In particular, the CFPB should compliance be dismantled. Consumer protection law predates Dodd-Frank, and there is absolutely no reason that state • Inconsistencies with oversight and compliance regulators, along with the Federal Trade Commission and of federal consumer financial protection laws the Department of Justice, cannot police financial markets (such as fair lending laws) to guard against fraud and criminal behavior.15
• Duplication in the examinations of financial Optimally, banking applications would no longer holding companies, despite the OCC’s and the be approved based on a regulator’s assessment of the Fed’s efforts to coordinate company’s risk profile, the owners’ ability to attract and maintain community support, or whether the agency Proponents of the multiregulator system argue that it believes the company can remain profitable. A good allows regulators’ performance to be measured against the reform tool would be to provide an optional federal record of other regulators, and that it confines mistakes to financial charter, with no chartering restrictions beyond limited jurisdictions. Similarly, they argue that competition ensuring the suitability of management and directors among regulators reduces the likelihood that a given agency through standard background checks. This charter could might refrain from raising too many objections about the provide an opt-out of countless activity restrictions in entities they regulate. The problem with these arguments return for meeting a higher equity ratio and agreeing to a is that they assume a degree of competition and diversity prohibition on receiving federal assistance.16
38 BANKING PERSPECTIVES QUARTER 3 2017 Ultimately, to eliminate the need for activity restrictions, REFORMS MOST LIKELY TO BE ENACTED the federal safety net has to be pared back. Congress can BY THE 115TH CONGRESS provide more market discipline and move toward such In Washington, wholesale reforms of any type are much a framework by lowering the amount of FDIC deposit rarer than changes that mildly alter the status quo, and insurance coverage to (at least) the pre-Dodd-Frank limit financial regulation is surely not the exception to this rule. of $100,000 per account. Even lowering the value to the So the near-term prospects of a complete transformation of pre-1980 limit of $40,000 per account would insure a level bank regulation, such as the one described in the previous nearly 10 times the average transaction-account balance section, are quite dim. However, Chairman Jeb Hensarling’s of approximately $4,000. Congress should also amend the Financial CHOICE Act, the only major reform bill to pass coverage limits so that they apply on a per-person basis and either chamber of Congress since the Dodd-Frank Act was that they cover only retail deposit customers.17 enacted, does include several major improvements to the current system, including a capital off-ramp provision. Activity restrictions could then be all but eliminated, and banks would be allowed to operate with relatively few The CHOICE Act would convert the FSOC into an regulatory requirements. Policymakers could easily justify information-sharing working group, end systemically jettisoning, for example, regulatory stress-testing and Basel important financial institution designations, and repeal capital and liquidity rules, and they should go so far as to Title VIII of Dodd-Frank, which created a new framework eliminate the remaining sections of the Glass-Steagall Act so for assessing the systemic risk associated with financial that banks can underwrite and deal in securities. Regardless institutions and financial market utilities involved in of how far Congress moves in this direction, they should clearing activities for financial transactions. It would reform AML and Bank Secrecy Act (BSA) rules so that banks replace Dodd-Frank’s orderly liquidation authority no longer serve law enforcement roles. At a bare minimum, (OLA) with new bankruptcy code provisions, and replace Congress should streamline the AML/BSA reporting process the CFPB with an enforcement-only agency that looks and adjust the thresholds for inflation from $10,000 (where nothing like the powerful rulemaking agency created by they were set in 1970) to $60,000. It makes little sense to Title X of Dodd-Frank. The CHOICE Act would also make criminalize the use of cash and to continue collecting millions many other regulatory reforms, such as repeal the Volcker of reports on lawful transactions. rule and make all financial regulatory agencies go through the regular appropriations process, thus increasing their Federal rules should focus on mitigating fraud and accountability to Congress. promoting disclosure of relevant information rather than narrowly defining and restricting the ways in which banks As of this writing, there is no Senate companion can employ capital. Policymakers should implement these legislation to the CHOICE Act, but the Trump types of reforms because they are the best way to introduce administration has signaled its willingness to replace more market discipline into the system, and because large parts of the Dodd-Frank Act. Executive Order they are the best way to allow financial intermediaries to 13772, signed in February, made it official administration evolve to meet changing customer needs. While this new policy to regulate financial markets consistent with seven approach does not guarantee a stable banking system and core principles. These principles are largely compatible macroeconomy, neither does the extensive and overly with the ideas behind CHOICE Act reforms, suggesting complex web of federal rules and regulations. Both theory the Trump administration would be agreeable to major and evidence suggest that the banking system will perform financial regulatory improvements. Several of these better when banks’ capital suppliers face more market principles are as follows: discipline.18 Laws that mandate disclosure and enhance enforcement through civil liability rules have a more • Empower Americans to make independent positive impact than activity restrictions, and evidence financial decisions and informed choices in the suggests that this type of disclosure and private monitoring marketplace, save for retirement, and build would work well even in the banking sector.19 individual wealth
BANKING PERSPECTIVES QUARTER 3 2017 39 Structural Limitations and Activity Restrictions
• Prevent taxpayer-funded bailouts interest and needs of the communities that they serve and to improve the current supervisory and regulatory framework • Foster economic growth and vibrant financial for CRA.”23 This statement suggests the administration markets through more rigorous regulatory would not support eliminating the CRA, even though doing impact analysis that addresses systemic risk so would be more consistent with empowering Americans and market failures, such as moral hazard and to make independent financial decisions. information asymmetry Similarly, while the Treasury report offers support for • Make regulation efficient, effective, and the capital off-ramp approach in the CHOICE Act, it also appropriately tailored calls for retaining “Explicit, appropriately risk-sensitive capital standards” and “Supervised stress testing tailored • Restore public accountability within federal based on banking organizations’ complexity.”24 Risk- financial regulatory agencies and rationalize based capital and size-based exemptions do not fix the the federal financial regulatory framework. core problems with the existing system because they still substitute regulators’ arbitrary judgments for those In fulfillment of the executive order, Treasury has of the market participants with the most at risk. These released a report on depository institution regulation, and it kinds of changes provide the wrong incentives for firms includes many specific ideas that are either in or consistent that want to grow, and at least two major U.S. banking with those in the CHOICE Act.20 For instance, the report crises have already originated with predominantly calls for making the CFPB’s director removable at will, smaller financial institutions. Nonetheless, it is much eliminating the Bureau’s supervisory authority, funding easier to gain political support for tweaking the the Bureau through the regular appropriations process, existing system in this manner, so these types of small and subjecting it to Office of Management and Budget adjustments are likely on the near-term horizon. apportionment. These changes very closely mirror those that Title VII of the CHOICE Act makes to the Bureau.21 The Treasury report also recommends that Congress reduce fragmentation, overlap, and duplication from the Though legislation that restructures the CFPB in this financial regulatory framework and suggests that such manner is unlikely to garner 60 votes in the Senate, it reforms “could include consolidating regulators with doesn’t have to because the Congressional Budget Office similar missions and more clearly defining regulatory (CBO) scored this component of the CHOICE Act as mandates.”25 Yet the report recommends broadening the providing budgetary savings. In fact, the CBO also reported FSOC’s statutory mandate so that it can play an increased that repealing Dodd-Frank’s OLA, as done in Title I of the role in coordinating regulation among the various agencies. CHOICE Act, would provide budgetary savings.22 Thus, If history is any guide, broadening the role of the FSOC in a simple majority vote in the Senate during the budget this manner will not improve the regulatory process, and reconciliation process would be enough to enact at least consolidating the financial regulators would eliminate the two major financial regulatory reforms. Naturally, the fact need for the FSOC. As with other biases toward the status that a federal court has already ruled the CFPB’s structure quo, consolidating regulatory agencies has always been unconstitutional adds pressure to adopt the CFPB changes politically problematic, while gently expanding the role of put forth in CHOICE. existing regulators is much easier to sell.
Other aspects of the Treasury report are somewhat Overall, the report suggests that Treasury has done inconsistent with the principles driving reforms in its best to support as many allies for reform as possible, the CHOICE Act, and are even partly at odds with the which increases the likelihood that popular changes administration’s own core principles. For instance, the such as higher thresholds for supervisory stress testing, report states that “It is very important to better align the comprehensive capital analysis review, and single benefits arising from banks’ CRA investments with the counterparty credit limits are in the near future. These
40 BANKING PERSPECTIVES QUARTER 3 2017 types of reforms tend to garner more widespread support markets drives innovation, lowers prices, prevents excessive because they provide regulatory relief to smaller banks, risk taking, and allows people to invest their savings in the but they represent tweaks to the current system rather best investment opportunities. than wholesale reforms. Because most major reforms will require congressional action, unless reform- Financial regulation should not protect people from minded conservatives make major gains in the midterm business or financial risk that they knowingly choose elections, the U.S. is more likely to enact these types of to accept. Instead, financial regulations should focus on small changes rather than sweeping financial regulatory punishing and deterring fraud and fostering the disclosure reforms. As of this writing, the two major reforms with of information that is material to saving and investment the best chance of passing into law are the CFPB reforms decisions. It should start from the following principle: and OLA repeal in the CHOICE Act. Firms that absorb more of their own losses do not need to CONCLUSION be heavily regulated. A major shortcoming of the existing system is that it narrowly defines the activities that banks For decades, U.S. financial regulation has failed because it micromanages people’s financial risk, substituting can perform, and restricts the ways in which they can regulators’ judgments for those of the investing public. employ capital, thus making it very difficult to evolve Government rules that profess to guarantee the safety of the to meet changing customer needs. Wholesale reforms banking system create a false sense of security, lower private are needed to help strengthen the banking and financial incentives to monitor risk, increase institutions’ financial system in the U.S., but implementing these reforms at risk, and protect incumbent firms from new competitors. It once will be very difficult to accomplish given the current is important to reverse these trends because competition in political environment. n
ENDNOTES fraser.stlouisfed.org/docs/historical/federal%20 Altered Bank Supervision.” NBER Working Paper reserve%20history/bog_members_statements/ No. 16825. February 2011. http://www.nber.org/ 1 Calomiris, Charles A. “Banking Crises Yesterday and laware_19910509.pdf (accessed July 10, 2017) papers/w16825 (accessed March 15, 2016) Today.” Financial History Review 17, no. 1 (2010): 4. 10 See press release, Federal Reserve Board 19 La Porta, Rafael, Florencio Lopez-De-Silanes, and Andrei 2 Calomiris, Charles A., and Stephen Haber. Fragile By of Governors. December 24, 1996. http:// Shleifer. “What Works in Securities Laws?” The Journal of Design: The Political Origins of Banking Crises and www.federalreserve.gov/BoardDocs/press/ Finance LXI, no. 1 (February 2006). http://onlinelibrary. Scarce Credit. Princeton, N.J.: Princeton University general/1996/19961224/default.htm (accessed wiley.com/doi/10.1111/j.1540-6261.2006.00828.x/ Press, 2014. July 10, 2017) pdf (accessed March 15, 2016) 3 Ibid. 11 12 U.S. Code §1844. Barth, James R., et al. “Do Bank Regulation, 4 Geithner, Timothy. “Remarks at the Forum on Global 12 12 CFR 226. Supervision and Monitoring Enhance or Impede Leadership: U.S. Competitiveness in a Globally 13 15 U.S. Code §1691, et seq. Bank Efficiency?” Journal of Banking & Finance 37 Integrated Economy.” Washington, D.C. July 25, 14 Butler, Henry, and Jonathan Macey. “The Myth of (2013): 2879–2892. 2007. https://www.newyorkfed.org/newsevents/ Competition in the Dual Banking System.” Cornell 20 U.S. Department of the Treasury. “A Financial System speeches/2007/gei070725 (accessed July 9, 2017) Law Review 73 (1988). That Creates Economic Opportunities Banks and 5 Ibid. 15 Katz, Diane, and Norbert Michel. “Consumer Protection Credit Unions.” June 2017. https://www.treasury. 6 Todd Conover’s testimony, Inquiry Into Continental Predates the Consumer Financial Protection Bureau.” gov/press-center/press-releases/Documents/A%20 Illinois Corp. and Continental Illinois National Bank: Heritage Foundation Backgrounder No. 3214. May 11, Financial%20System.pdf (accessed July 21, 2017) Hearings Before the Subcommittee on Financial 2017. http://www.heritage.org/government-regulation/ 21 See H.R.10 - Financial CHOICE Act of 2017. https:// Institutions Supervision, Regulation, and Insurance report/consumer-protection-predates-the-consumer- www.congress.gov/bill/115th-congress/house- of the Committee on Banking, Finance, and Urban financial-protection-bureau (accessed July 12, 2017) bill/10/text (accessed July 21, 2017) Affairs, House of Representatives, Ninety-Eighth 16 See Dwyer, Gerald, and Norbert Michel. “A New Federal 22 In May 2017, the Congressional Budget Office (CBO) Congress, Second Session, September 18 and 19 Charter for Financial Institutions.” Prosperity Unleashed: reported that enacting the CHOICE Act would reduce and October 4, 1984. https://fraser.stlouisfed. Smarter Financial Regulation, ed. Norbert Michel. The federal deficits by $24.1 billion, and that the biggest org/scribd/?title_id-=745&filepath=/files/docs/ Heritage Foundation, Washington, D.C., 2017. http:// historical/house/house_cinb1984.pdf#scribd-open www.heritage.org/sites/default/files/2017-02/23_ budgetary savings would come from those provisions (accessed July 9, 2017) ProsperityUnleashed_Chapter23.pdf that repeal Dodd-Frank’s Orderly Liquidation Authority (OLA) and restructure the CFPB. Treasury 7 Conover, p. 214. 17 The optional charter approach should explicitly has decided to release a separate report on OLA. As 8 Conover, p. 216. forbid the use of federal deposit insurance, as well of this writing, the study is incomplete. 9 See John P. LaWare, testimony before the as all forms of government loans and assistance. Subcommittee on Economic Stabilization, Committee See Dwyer and Michel. 23 U.S. Department of the Treasury, p. 9. on Banking, Finance, and Urban Affairs, U.S. 18 White, Eugene N. “‘To Establish a More Effective 24 U.S. Department of the Treasury, p. 10. House of Representatives, May 9, 1991. https:// Supervision of Banking’: How the Birth of the Fed 25 U.S. Department of the Treasury, p. 30.
BANKING PERSPECTIVES QUARTER 3 2017 41 RETHINKING SAFETY AND SOUNDNESS SUPERVISION BY GREG BAER THE CLEARING HOUSE
IN THE Q2 2017 EDITION of Banking Perspectives, Jeremy Newell and I wrote “How Supervision Has Lost Its Way.” That article garnered a lot of interest and triggered an outpouring of calls from bankers who felt that we had captured the strange, secret supervisory world they are attempting to navigate. The article concluded with a promise of proposed solutions in a future issue, and here they come.
To be clear, the focus here is (1) safety and soundness To begin, here are principles that could guide a supervision, (2) of banks (as opposed to their holding thoughtful re-evaluation of how safety and soundness companies or non-bank affiliates), and (3) large banks in supervision of large banks should be conducted. particular. That is not to say that safety and soundness supervision should not be rethought for non-bank PRINCIPLES FOR REFORM affiliates of large banks, or for community banks, but they SAFETY AND SOUNDNESS SHOULD BE EXAMINED AND are not the focus of this article. (Indeed, as we go to press, EVALUATED INDEPENDENTLY FROM COMPLIANCE the Federal Reserve Board has just proposed a new rating Prior to the last seven or so years, banking supervision system for bank holding companies.) generally separated safety and soundness from consumer 42 BANKING PERSPECTIVESI QUARTER 3 2017 BANKS SHOULD BE MONITORED FOR SAFETY AND SOUNDNESS, AS WELL AS FOR CONSUMER COMPLIANCE. HOWEVER, THE TWO SHOULD BE REVIEWED SEPARATELY AND THE PROCESSES, GUIDELINES, AND REGULATIONS NEED CONSIDERABLE REFORMS.
compliance. Indeed, the CAMELS rating system was adopted these days seems uncontested, the latter has been in 1978 and followed in 1979 by a separate consumer rating implicitly rejected by at least some bank examiners. system. There are two reasons for supervisors to bifurcate: (1) Indeed, much of “How Supervision Lost Its Way” it’s a good idea, and (2) it’s the law. detailed the problems that arise when examiners contort to treat healthy banks as having soundness problems It’s a good idea to separate safety and soundness from based on compliance violations or immaterial process consumer compliance because they are two different fouls and use that supposed unsoundness as grounds for functions with very different goals. Thus, a bank with blocking expansion. strong capital and earnings should be evaluated for consumer compliance purposes in the same way as one The law is crystal clear. On the consumer compliance with weak capital and earnings. Conversely, a bank side, Section 1011 of Dodd-Frank provides that the that commits a violation of a consumer law should be CFPB “shall regulate the offering and provision of evaluated for safety and soundness purposes in the same consumer financial products or services under the way as one that does not. While the first proposition Federal consumer financial laws.” The Bureau is
BANKING PERSPECTIVES QUARTER 3 2017 43 Rethinking Safety and Soundness Supervision
granted clear and exclusive rulemaking authority.1 Over the past 10 years, Wells Fargo’s spreads, like those With respect to banks with more than $10 billion in of other companies, have varied based on economic and assets, “The Bureau shall have exclusive authority financial conditions. However, the “reputational risk” to require reports and conduct examinations … (a) of the current scandal clearly has proven immaterial to for purposes of – (A) assessing compliance with the those spreads. At all points since issues first came to light requirements of Federal consumer financial laws; (B) on September 8, 2016, however, spreads have remained obtaining information about the activities subject to significantly below their 10-year average. Indeed, they such laws and the associated compliance systems or remain near their 10-year lows. procedures of such persons; and (C) detecting and assessing associated risks to consumers and to markets Thus, Wells Fargo appears to put the lie to the notion that for consumer financial products and services.” consumer compliance risk is a safety and soundness risk. Note: “exclusive.” The ramifications of the truth are significant for As any banker could tell you, however, the federal banking supervision. Banks can safely be permitted banking agencies have increased their supervision of to manage their own reputations rather than having consumer financial laws since being divested of it. How examiners manage their reputations for them. And safety could that be? On to our next principle. and soundness supervision can go back to focusing on safety and soundness. For example, many are surprised to “REPUTATIONAL RISK” IS RARELY, AND LIKELY learn that in the wake of the clear and wholesale transfer NEVER, A SAFETY AND SOUNDNESS RISK of regulation, supervision, and enforcement over the In using compliance problems to block bank consumer compliance laws from the banking agencies expansion, regulators often default to the following to the CFPB, the banking agencies have by all accounts syllogism: (1) Compliance problems (including legal increased the scope and severity of their supervision and violations and alleged deficiencies in process that could enforcement in this area. lead to a legal violation) create “reputational risk” – that is, the risk that a violation of law could damage a bank’s THE AGENCIES SHOULD ASSESS COMMUNITY reputation.2 (2) Damage to the bank’s reputation could REINVESTMENT WHEN EVALUATING COMPLIANCE lead to serious financial harm, imperiling the bank’s WITH THE COMMUNITY REINVESTMENT ACT solvency. (3) Therefore, any compliance problem is also a Aside from being improperly treated as “reputational safety and soundness problem. risk,” consumer compliance has also been contorted into an assessment factor under the Community Key question: How often has damage to a bank’s Reinvestment Act (CRA). So, consumer compliance reputation led to serious financial harm that imperiled a factors are again transformed into a brake on expansion bank’s solvency? Ever? because CRA compliance is a statutory factor with regard to certain applications. Let’s consider the recent case of Wells Fargo. Regardless of how one views the merits of the charges The purpose of the CRA was to require “private brought against it, Wells Fargo has unquestionably financial institutions [to] play the ‘leading role’ in suffered reputational damage as a result of alleged providing the capital required for ‘local’ housing and consumer compliance problems. economic development needs.”3 Thus, under the CRA, the ratings are defined as an “outstanding [or satisfactory, And what has been the effect of this reputational damage? needs to improve, or unsatisfactory] record of meeting community credit needs.” 4 The statute directs the agencies Let’s look at its credit default swap (CDS) spreads – the to “assess the institution’s record of meeting the credit best measure of its perceived chance of insolvency, and needs of its entire community, including low- and thereby defaulting on its debt (see Figure 1). moderate-income neighborhoods….”5
44 BANKING PERSPECTIVES QUARTER 3 2017 Notwithstanding the fact that the CRA statute and the for expansion if, among other things, a subsidiary bank three assessment factors included in its implementing has a CAMELS rating of “3” or below, a component regulation clearly focus on credit availability, regulators Management rating of “3” or below, or a Needs to Improve have increasingly included in their assessments other or Unsatisfactory CRA rating. criteria, particularly consumer compliance or other issues outside the scope of the CRA.6 For perspective, consider how odd such an approach looks in the context of other industries. If Pfizer BANKS CAN PERFORM MULTIPLE FUNCTIONS AT experiences a problem with one of its drugs, the THE SAME TIME FDA does not prohibit it from developing new ones Improperly treating compliance issues as safety and until the troubled drug is fixed. If General Motors soundness problems and CRA failures would be – to produces deficient ignition switches, the Department borrow a legal phrase – a “harmless error” if doing so did of Transportation does not prohibit it from developing not have significant consequences for banks’ ability to new vehicles or opening new dealerships until all the manage themselves efficiently and serve their customers. switches are recalled and repaired. If Target suffers But it does. Here we see the relevance of the Federal a data breach, the FTC does not prohibit it from Reserve’s Supervisory Letter 14-02, issued in 2014, opening new stores until the FTC is satisfied with its without notice and comment. (The OCC by all accounts cybersecurity. Rather, the FDA presumes that one group maintains a similar policy but has not reflected it in of researchers can fix the problem with one drug while writing.) That letter effectively states that except in rare other researchers work on other drugs; DoT presumes cases, the Federal Reserve will not approve any application that different people at General Motors fix ignition
FIGURE 1: WELLS FARGO 5-YEAR CREDIT DEFAULT SWAP SPREAD