Financial Justice, 26th Edition: Shadow Banks

Jun 01, 2023

As Republican lawmakers work to undermine the efficacy of the Financial Stability Oversight Council, the body born out of Dodd-Frank to monitor financial risk, shadow banks – the lightly regulated likes of private equity and hedge funds – continue their program of unabated growth. The massive shocks to the banking sector during the crisis only served to enlarge these nonbank institutions, and their ballooning assets-under-management figures enable them to encroach on unexpected parts of the system.

Last week, House Financial Republicans advanced by a 26-22 vote H.R.3556, the “Increasing Financial Regulatory Accountability and Transparency Act.” Ahead of the vote, AFR sent a letter to McHenry and Waters opposing the bill on the grounds that it would hamstring FSOC’s ability to monitor financial risk under the guise of making it more transparent.
European Central Bank vice president Luis de Guindos warns about “increased risks for the financial system” from shadow banks. Guindos cites the high interconnectedness between the bank and non-bank sectors as heightening the “scope of contagion,” especially as the latter is under threat by rising interest rates and diminishing asset prices. He offers some policy approaches.
A Boston Fed paper explores how asset fire sales by nonbanks represent an unseen threat to banks. Difficult to trace, these fire sales have great potential to spill over into other banking operations due to the growing interconnectedness of nonbank entities. Read the paper here.

FINANCIAL STABILITY

Clawbacks and Compensation.

Warren and Vance now have nearly half the members of the Senate Banking Committee on board with a bipartisan bill to claw back compensation from failed bank executives. (AFR is a big fan of this step.) “This is not just for show,” Warren told Politico. “We actually want to make change, and we've got a bill where we can get this done.” Vance expects a markup in a few weeks.

First Republic reportedly paid dozens of employees over $10mn apiece annually, including an unnamed banker who was not a top executive but still raked in $35mn last year. (Dimon topped out at $34.5mn.) The bank’s incentives drove compensation up to an average of $310,000 per employee last year, rewarding things like “arranging home loans, amassing deposits and growing wealth-management portfolios.”

Debt Ceiling.

Even if the debt ceiling deal clears, writes Politico, the threat to the banks and to the economy won’t end. When the ceiling is raised, the Treasury will need to increase borrowing quickly by issuing more government debt, likely cutting into the reserves banks can tap into at the Fed, and raising borrowing costs.

Tougher on Risky Banks.

The Office of Comptroller of the Currency plans to come down harder on banks that fail to address “persistent weaknesses.” Guidelines released in the Policies and Procedures Manual (PPM) on Thursday would target banks over $50bn in consolidated assets. Hsu has previously expressed a desire to crack down on “too big to manage” banks. Progress? TBD.

The OCC released a new version of the Comptroller’s Handbook on liquidity. Changes include a paragraph on “surge deposits,” underscoring the need for bank examiners to monitor deposit-flow risks. More details from Bank Reg Blog.

Commercial Real Estate.

As a percent of their total loans, banks now hold more commercial real estate loans than in the last quarter of 2007. After loading up during periods of low interest, heightened rates mean these borrowers will have to pay more to borrow when they refinance in the coming years, writes Mayra Rodriguez Valladares.

A report from Fitch Ratings highlights that among banks with <$100bn, commercial real estate loans represent a larger percentage of total capital than for their larger counterparts.

Bank Mergers.

Bank Reg Blog summarizes the positions of various parties to the debate when it comes to the Department of Justice’s review of its bank merger guidelines, which haven’t been updated since 1995.

More on SVB.

First Citizens laid off nearly 500 Silicon Valley Bank employees after its purchase, reports Axios. That’s almost 3% of FC’s total workforce.

Also: the FDIC says that Q1 bank profits across the board were fairly healthy even as SVB and Signature collapsed. Net income jumped to $79.8bn from the previous quarter, though the figure includes the purchases of the fallen banks.

Social Media Bank Runs.

A study from the St. Louis Fed examines the speed and magnitude of bank runs in historical context. While technology a can explain some minor increases among households and small business depositors, large corporations have been able to electronically withdraw funds since the late ‘70s. A “lightning fast electronic run” at Continental Illinois in ‘84 took 10 days; First Republic’s run took 7 to 14 . Instead of any novel technology, the SL Fed says the standout factor was the banks’ depositor bases.

Wall Street and China.

McHenry wants the Biden administration to trim down planned rules applying to U.S. outbound investments in Chinese companies. In a letter to Yellen, McHenry questions the effectiveness of the administration’s attempts to keep American cash from driving Chinese technological innovation.

JPMorgan CEO Dimon will travel next week to Shanghai to meet a lineup of American and Chinese business elites for a summit, continuing a long tradition of Wall Street seeking placid and profitable ties between the world’s two largest economies.

Monetary Policy and Crises.

While the Barr report incriminated both SVB and supervisors, former governor of the Reserve Bank of India Raghuram G. Rajan suggests that it didn’t ID one of the leading culprits: the Fed’s monetary policy. A December 2022 paper from the Centre for Economic Policy Research found that many banking crises, in 17 countries across 150 years, were preceded by a parabolic interest-rate path in the long-term.

Comerica’s Compliance.

American Banker exposes private communication between Comerica Bank officials which express concerns about the legality of its relationships in the purview of its contract with the Treasury Department to operate a public benefits payment system.

Auditors.

University of London professor Atul K. Shah writes that government auditors would be a better choice to police institutions rather than large, private firms like KPMG, which oversaw audits on SVB, Signature and First Republic.

Regional Banks.

Regional bank stock values are exhibiting an uptick after the lows bottomed-out earlier this month. Bargain prices mixed with the upturn are attracting cautious investors who are interested in buying the dip, but may not be entirely convinced by the recovery signs yet.

And: the banking crisis has disproportionately affected the west coast over the east. Three of the four failed banks were headquartered in California, as are the handful of other regionals under the microscope like PacWest and Western Alliance. Some of the banks were exposed to Silicon Valley’s entrepreneurs and venture capital, but not all of them.

JPMorgan and the Super-Rich.

Before the pandemic, JPMorgan created an international unit called 23 Wall, which targets the ultra-wealthy and their investment firms. Bloomberg reports many of these deep-pocketed clients are increasingly interested in using family offices and “loosely regulated money managers.” JPMorgan’s private bank opened 40,000 new accounts in the past ten weeks. On average, they took on about one new >$100mn-in-assets client a day last year.

KC Fed’s Presidential Pursuit.

The Kansas City Fed is still without a president after Esther George’s retirement this January, per WSJ. Now entering its second year, the search has been ongoing since May 2022 and wrought with challenges. Strong candidates identified by the committee have withdrawn their interest. One, an executive at a community bank, dropped out after discovering the Fed’s restrictions on personal financial holdings.

CONSUMER

CFPB and Equity.

A new report from Public Citizen highlights the strides the Consumer Financial Protection Bureau has made toward racial equity in its consumer protection work.

Related: AFR released a blog uplifting the work the Consumer Financial Protection Bureau continues to undertake even amid attacks related to its Supreme Court fight on whether to subject it to annual congressional appropriations.

Overdraft Revenue.

According to data from the CFPB, revenue from overdraft fees fell nearly 50% in Q4 compared to three years earlier, per American Banker. For all of 2022, banks reported $7.7bn in these fees, a 35% decline from 2019. Notably, banks have not increased other fees to make up for these slashes. CFPB is currently considering new rules on overdrafts.

Buy Now, Pay Later.

An investigation by Consumer Reports finds most popular buy now, pay later apps – Paypal, Klarna, Afterpay, etc. – tend to be fairly safe in regard to their privacy, transparency and security policies. Two, Perpay and Zilch, fall short. Loans from BNPL providers increased from $16.8mn to $180mn from 2019 and 2021, with the most common borrowers on average being young, Black or Hispanic or female. Despite the generally high marks, CR identifies shortcomings.

CAPITAL MARKETS

Capital Markets Bills.

AFR sent a letter to McHenry and Jeffries opposing bills that the House passed last night. Two would revisit standards to define “accredited investors.” Another would lower the bar to become an “accredited investor.” A fourth would enable issuers to receive confidential reviews of draft registration statements instead of immediately filing a statement for public viewing. The final involves emerging growth companies.

PRIVATE MARKETS

Private Credit.

Tech investment group SoftBank plans to move into private credit, according to Bloomberg, as rising interest rates mean an attractive rise in returns. Recent years have seen rapid growth in direct lending. Apollo’s Jim Zelter says default rates of 2% to 3% “may be challenged by companies that are having higher interest costs across the board.”

PE and Retail.

According to S&P Global, an increasing number of institutional investors, especially public pension funds, have overallocated into private equity since 2019, limiting their possibilities for new commitments. This squeeze on fundraising prospects has pushed PE fund managers toward trying to court retail investors.

SEC Scrutiny.

The SEC’s examinations unit has issued a records request pertaining to some unidentified private equity firms’ money transfers, investor communications and emails with SVB. The agency’s interested in how some firms withdrew deposits from the bank before its collapse. Bloomberg notes that queries from these units often don’t lead to investigations and doesn’t necessarily indicate a formal probe is on the horizon.

CRYPTO

Crypto as Funds.

Cryptocurrencies are “funds” and crypto platforms are “financial institutions” under the Electronic Fund Transfer Act, ruled the U.S. District Court for the Southern District of New York in February. The defendant in the case, Rider v. Uphold HQ Inc., asserted crypto didn’t constitute fit the bill of a “fund” that would be covered by the EFTA.

Transparency.

A survey by FT finds that transparency is lacking among crypto companies. Eight of the 21 prominent companies FT approached either refused to share basic information, such as where they’re headquartered. Others provided only partial answers. Their responses (or non-responses) can be found here.

Crypto vs. Traditionals.

Some traditional groups in the financial sector, including Charles Schwab and Standard Chartered, are working to build their own digital markets trading platforms, reports FT. A survey by EY-Parthenon of 250 asset managers found that half of them would switch from a “crypto-native group” to a “traditional-backed company that offered the same services.” Ninety percent would trust a traditional group to serve as custodians over their tokens.

CLIMATE and FINANCE

Republicans Threaten Climate Club.

There’s been an exodus of members from the world’s largest climate alliance for insurers, the Net Zero Insurance Alliance, after Republican attorneys general accused the organization of antitrust violations. Bloomberg calls the AGs’ move “a key moment in the GOP’s campaign to wipe environmental, social and governance metrics off the financial map.”

The Uninsurables.

“The climate crisis is becoming a financial crisis,” writes NYT. Climate-related threats have made parts of the country “uninsurable,” as State Farm recently pulled out of selling coverage to California homeowners. Florida’s system is backed by Citizens Property Insurance Corporation, a state company that provides windstorm coverage for homeowners who couldn’t get private insurance. But they won’t cover homes that would cost more than $700,000 to replace, or more than $1mn in Miami-Dade and the Keys.

Financial Justice