Banking regulatory tide set to turn in 2023

The big themes: Capital, climate, the Community Reinvestment Act, mergers and acquisitions, digital assets, fintech partnerships and, now, liquidity.

The new vice chair for supervision at the Federal Reserve, Michael Barr, wasted no time pointing to capital at the nation’s largest banks as an immediate action item. In a September speech, Barr noted that the Fed was undertaking a “holistic” review of bank capital requirements. During a separate speech in December, he went a step further when he described the current requirements for capital levels of banks in the United States as “toward the low end of the range described in most of the research literature.”

While the industry waits for clarity on proposed changes to capital requirements—reportedly expected early this year—one area where Barr has moved to assert his supervisory authority is stress testing. On Feb. 9, the Fed released its annual stress test scenarios, the hypothetical strains used to test the nation’s economy. The scenarios included a new component—the “exploratory market shock” for the country’s eight largest banks.

Fed authorities are quick to point out that this shock will not contribute to the capital requirements set by the test; but in our estimation, the outcomes from this year’s stress testing will be analyzed closely by the Fed and likely will provide a meaningful data point as the Fed looks to adjust capital requirements for big banks.

The national banks with assets over $100 billion will be the first to see the impact from any changes to capital requirements. In time, institutions with assets below this threshold may likely see the trickle-down effects.

All three primary bank regulators spent considerable time in 2022 discussing climate-related financial risk. While the OCC and FDIC have both published principles for climate-related financial risk management targeted initially at large institutions, the Fed has been slower to release climate-related guidance. Fed Vice Chair Barr has indicated that assessment of climate-related financial risk presents a priority that requires further analysis.

The Fed is expected to launch a pilot program in early 2023 to conduct scenario analyses targeting the six largest U.S. banks to better understand the risk posed by climate change. This assessment will be done carefully, as both Barr and Fed Chair Jerome Powell have publicly commented that the Fed is not a climate regulator.

The outcomes from the evaluation of climate on the banking system will likely have broader implications. The Fed, OCC and FDIC are anticipated to work together on supervision efforts, initially focused on climate risk at large banks. To date, the collective commentary from FDIC Chair Martin Gruenberg and Acting OCC Chair Michael Hsu points to climate risk as an issue that will affect all banks; further, it implies an increasing focus on climate at all banks. Gruenberg has indicated in his remarks that smaller and midsize banks should plan wisely to prepare for climate-related risk requirements.

It is worth noting that no regulator has indicated it plans to say which businesses banks should or should not do business with; however, the commentary from the agencies points to greater emphasis on understanding how climate-related financial risks—whether physical or transition-related—will affect the bank and what the bank is doing to monitor these risks to mitigate future losses.

As FDIC Chair Gruenberg said in December, "… while the U.S. government may provide assistance with the costs associated with many severe weather events, financial institutions should not be wholly dependent on this assistance, whether directly or indirectly."

The often talked-about modernization of the Community Reinvestment Act, known as CRA, will see a final rule released in 2023—possibly as early as the first half of the year—and will likely result in a significant uplift in compliance for all institutions.

With more than 650 comments submitted on the joint proposal released in May 2022, the list of concerns from the industry is long. Some of the more prominent ones address the complexity of evaluation methods, the timelines for implementation (is the proposed 12 months enough?), how retail lending is defined and how the agencies will use significantly more granular information submitted by banks for compliance.

The final rule will shed light on those concerns and provide greater clarity around the asset thresholds that dictate the overall level of compliance required for banks of varying sizes. However, the fact remains that modernization will result in a substantial reform to the 45-year-old law originally put in place for a nondigital banking landscape.

Once a final rule is published, the impact on compliance teams, bank technology used in the compliance function and the overall effort to report data will result in considerable resource strains.

Further, given the scope of a proposed rule on providing insight into how banks serve low- to moderate-income communities, CRA compliance will be a bigger factor in merger reviews going forward.

The current macroeconomic and regulatory environment has created a one-two punch to the gut of banking mergers and acquisitions. January 2023 saw only six deals announced, amounting to the slowest January in 14 years, according to S&P Global Market Intelligence data.

Yet even when the economy moves beyond current macroeconomic headwinds, the crux of the matter remains: Bank regulators are already looking more closely at deals, even without a change to existing regulation, a trend directly attributable to President Biden’s July 2021 Executive Order on Promoting Competition in the American Economy.

The most recent data from the Fed shows the processing time to review M&A proposals has increased. For M&A proposals that did not receive adverse public comments, average processing time in the first half of 2022 was 65 days, up from 62 days in 2021 and 53 days in 2018. More onerous were proposals that gleaned adverse public feedback; the average processing time in the same period climbed to 197 days, compared to 186 days in 2021 and 113 days in 2018.

And it wasn’t just the largest banks that saw the length of review increase. Community banking organizations with $1 billion to $10 billion in assets also saw their approval times increase. Processing took an average of 90 days in the first half of 2022, compared to 51 days a year earlier.

The regulatory leaders at the primary banking agencies are all on record characterizing the current measures for reviewing bank mergers as outdated. Yet clear commentary on how the reviews should be handled has not been presented.

Speculation and commentary on how merger reform may take place continues to build. During the OCC’s bank merger symposium on Feb. 10, OCC Senior Deputy Comptroller Benjamin McDonough pointed to his agency’s contention that the merger review process deserves renewed consideration. He said the Herfindahl-Hirschman Index, a commonly accepted measure of market concentration, is a poor proxy for measuring bank market share.

Since late 2022, the landscape for digital assets has been defined by volatility. Uncertainty, combined with public commentary from banking regulators, culminated in a joint statement in January by the Federal Reserve, the FDIC and the OCC on crypto-asset risks to banking organizations. Banking business models with a significant concentration of offerings to digital asset companies would be “inconsistent with safe and sound banking practices,” their joint statement said.

Without a defined framework that includes offering digital assets products, both the regulators and banks themselves may struggle to figure out what constitutes safe and sound banking practices. This has left some digital asset firms without banking partners, while others have landed a banking relationship with banks historically not serving this space.

With increased concern related to digital assets, banks are certain to see greater scrutiny, especially in the areas of anti-money laundering, enhanced due diligence around onboarding new customers and overall liquidity management of digital asset customers.

The increasing number of partnerships between banks and consumer-focused fintech organizations through banking as a service is also drawing increased scrutiny from the OCC and FDIC.

In a September 2022 speech, Acting OCC Comptroller Hsu stated: “The growth of the fintech industry, of banking-as-a-service (BaaS), and of big tech forays into payments and lending is changing banking, and its risk profile, in profound ways.” Core to the concern is the blurring line between banking and fintech, he noted, adding: “(When) do customers go from being the client to becoming the product and how are consumer protections maintained?” 

A large portion of BaaS partnerships exist at banks that have under $10 billion in assets, with nearly one-fifth at banks with total assets under $1 billion. The risk to institutions of this size rapidly expanding into such partnership focuses on four primary areas—people, policy, process and technology.

Each of these four areas deserves a detailed and thorough discussion. But simply put, without adequate technology to handle the volume of transaction and account activity, along with commensurate processes, detailed policies for monitoring compliance, and knowledgeable people to support these complex arrangements, blind spots will surface. These could lead to regulatory noncompliance or worse, including financial penalties and losses.

In 2022, the OCC stepped up its regulatory review of fintech partnerships and even took formal action against one institution for failures in its monitoring of fintech partners. The primary focus of both the OCC and the FDIC includes monitoring of programs, staffing levels, and compliance with the Bank Secrecy Act, the Anti-Money Laundering Act and the regulations of the Office of Foreign Assets Control.

The failure of Silicon Valley Bank and other recent turmoil in the sector has underscored the need for financial institutions to evaluate the need to update existing liquidity stress indicators, metrics, guidelines, and limits. Leadership teams may also consider monitoring the utilization of borrowers’ unfunded lines of credit and determining the corresponding impact on the institution’s liquidity position, as well as analyzing borrowers’ credit quality as access to capital tightens.

During hearings on Capitol Hill in late March, Federal Reserve Vice Chair Michael Barr indicated changes that could be coming for mid-tier banks with assets above $100 billion. In addition to capital rules that were already under consideration, the Fed is now weighing liquidity requirements.

Additionally, in a March 30 briefing, President Biden called on regulators, not legislators, to reinstate rules that would toughen oversight of banks between $100 billion and $250 billion in assets. Key points of focus in the president’s remarks included liquidity requirements and enhanced liquidity stress testing.

The omission of congressional action in the president’s briefing keeps the regulators, rather than Congress, in the driver’s seat. Simply put, this means changes will be felt sooner under existing regulatory authorities as any action from Congress would be difficult given the division of power between the House and Senate.