AI-Driven Banking and Its Discontents
Editors’ Note: Financial Justice enabled the Substack platform’s payment function. It’ll be free for everyone, forever. But we are fighting a very powerful, well-financed industry: Wall Street. Donations are entirely optional. But: If you appreciate what we do and have some spare change, consider clicking here to give. Thank you!
These days, you can use artificial intelligence for more than just churning out nonsense essays or cobbling together other people’s art into disturbing imitations of human creativity. Financial institutions use the more advanced cousins of chatbots and generative models, driven by Big Data, to make decisions: Who gets a mortgage? Is this transaction fraudulent? And while we’re a far cry from the likes of HAL-9000 refusing to open the pod bay doors, rapid innovation in AI has given rise to new fears over financial stability and market fairness.
On Monday, the Biden administration issued an executive order that “establishes standards for AI safety and security, protects Americans’ privacy, advances equity and civil rights, stands up for consumers and workers, promotes innovation and competition,” and more. While the order applies broadly to artificial intelligence innovation in a wide swath of sectors, financial regulators will have their own set of tasks:
The Treasury will release a report on “AI-specific cybersecurity risks in banking.”
The CFPB and the Federal Housing Finance Agency will monitor lending bias, and issue guidance on discrimination in tenant screening systems with the Department of Housing and Urban Development.
The FTC was encouraged to “ensure that consumers and workers are protected from harms that may be enabled by the use of AI.”
Regulators will broadly be encouraged to protect against AI threats to financial stability.
Recently, the SEC’s Gensler warned a financial crisis is “nearly unavoidable” if regulators don’t address AI-related threats, fearing institutions might use the same set of base models created opaquely by external tech companies to make decisions.
There’s been evidence that discrimination is rampant when AI is applied to financial services, since Big Data reflects the broader problem of human prejudice. Earlier this year, the Fed’s Michael Barr flagged the specter of AI-driven discrimination in mortgage lending. Indeed, an AP investigation found that mortgage algorithms were routinely more likely to reject applicants of color.
FINANCIAL STABILITY: FSOC Gets a Rulebook – Bank Mergers – Check Fraud – Audit the Fed?
CONSUMER: Immigration and Lending – Frequent Flying – Payday Probes – Insurance Discrimination – Student Loans
CAPITAL MARKETS: Retirement Saving – Buybacks – Disaggregation – Conflicts of Interest – Journalists + Investors = ? – Empowering Main Street?
PRIVATE MARKETS: Financial Engineering in Hospitals – Firm Fraud – High Rates – SolarWinds Lawsuit – Endowment Money at Risk – Other PE News
CRYPTO: SBF and FTX – SafeMoon – Crypto Accounting
HOUSING: Inflated Commissions – Offices to Homes – Weak Mortgage Market – Florida’s Insurance
CLIMATE AND FINANCE: Don’t Water Down Climate Disclosure – Insurance Data Collection – The Climate Fight and the Fed – Oil Refiner Finance
Feedback? Reach us at afrnews@ourfinancialsecurity.org
FINANCIAL STABILITY
FSOC Gets a Rulebook
The Financial Stability Oversight Council approved new procedures for designating systemically important financial institutions (SIFIs), an important step after the Trump-era regulators made this action virtually impossible. Details and comment from Alexa Philo, senior banking and systemic risk analyst at AFR:
“Many risks in the nonbank sector, from insurance to private equity to hedge funds to asset management, are becoming increasingly serious and in need of closer attention. Dramatic growth in size, exposure to risks and connections among these entities and with traditional banks have put regulators in the dark and left the financial system and broader economy dangerously exposed to instability.”
Bank Mergers.
House Financial’s Barr and Fitzgerald sent a letter to the Fed, FDIC and OCC chiefs urging “timeliness” in their review of bank mergers, with an eye toward speeding them up. A reminder: the banking regulators have not yet revised merger guidelines, something long on the agenda. AFR has previously called for swift action on mergers “to mitigate the adverse effects of bank consolidation, which include increased evictions, higher rates of debt collection, and decreased access to credit for consumers and businesses.”
Check Fraud.
Even though banks receive fewer checks these days (71% of Americans use their banks’ mobile apps or desktop platforms, per a recent ABA analysis), check fraud has been on a rapid rise. Whenever something financially weird that may point to criminal activity happens, banks file a suspicious activity report (SAR) with the Financial Crimes Enforcement Network (FinCEN). Last year, the agency found that the number of SARs related to fraudulent checks topped out at over 680,000, almost double from 2022.
Audit the Fed?
Unlikely, since the Senate shot down Rand Paul’s amendment to give the Government Accountability Office the power to scrutinize the Fed’s activity.
CONSUMER
Immigration and Lending.
A few weeks ago, the CFPB and Department of Justice communicated that banks couldn’t use immigration status in any “unnecessary or overbroad” way to decide whether to issue credit. A cadre of House Republicans led by Rep. Vance wants them to walk the guidance back. They assert that allowing who they call “illegal immigrants” to access credit would threaten banking sector soundness, and more broadly financial stability. While we’re on the topic of threatening financial stability: In 2018, 6 of the 11 signatories on this letter voted in favor of S.2155, which rolled back some Dodd-Frank protection and has been considered one of the causes of this year’s banking crisis. The other 5 weren’t around yet.
Frequent Flying.
In their work to reduce credit card fees, Sens. Durbin and Marshall – also the lead sponsors of the Credit Card Competition Act, intended to strike at the Visa-Mastercard duopoly over credit transaction networks – sent a letter to Secretary of Transportation Buttigieg and CFPB Director Chopra, questioning what their agencies are doing to “protect consumers against unfair and deceptive practices” in the frequent flyer and other loyalty programs offered by airlines. They cite abusive and deceptive practices, such as arbitrary changes to systems that may devalue points that customers accrued when they were worth more, or how the ability to purchase points often costs far more than they’re worth at redemption.
Payday Probes.
Since the start of last year, predatory payday lenders – the nonbanks that extend short-term, high-cost loans to consumers – have blocked at least five investigations into their dubious business practices, WashPost reports. Federal court filings and interviews suggest the uncertainty created by the as-yet undecided CFPB v. CFSA has allowed companies to slow CFPB investigations and preempt enforcement actions. In one example, the agency sued Populus Financial Group, operator of Ace Cash Express, for hiding or intentionally obscuring free repayment plans from financially burdened borrowers and executing unauthorized debit card withdrawals. Populus’ lawyers asked the judge to dismiss the case; three months later, the court issued a stay. Other payday lenders, like Purpose Financial’s Advance America, have refused to submit documents to the CFPB’s investigators, similarly citing the Supreme Court case.
Insurance Discrimination.
Regulators in Maryland found that Erie Insurance, a home and auto insurer, discriminated against Black and Hispanic people with exclusionary sales practices. Independent agents had accused Erie of punishing them for selling policies to Black and Hispanic customers that lived in areas of cities like Baltimore that the company said carried too much risk. Officials determined that the practices were “designed to reduce business, and did reduce business, in dense urban areas with high minority populations.” The company has previously been accused of redlining in New York and Pennsylvania.
Student Loans.
The resumption of student loan payments has “hit HBCU graduates especially hard,” since HBCUs tend to serve more low-income and first-generation students who have to take on more loans. The Brookings Institute’s Andre Perry said the payment pause helped Black borrowers save for their future.
Related: The CFPB is investigating a spate of consumer complaints related to poor customer service among loan processing services, like Mohela and Nelnet, among others. Some report long wait times with customer service, many long enough that borrowers hang up instead of sticking it out. When they are able to speak to someone, whether an actual person or an automated system, they’re given poor guidance. Advocates have also reported that debt cancellations haven’t always appeared in borrower accounts, “a possible deceptive practice.”
And: Changes to the Free Application for Federal Student Aid will see pretax contributions made to retirement accounts, like 401(k)s, be excluded as income in the formula that calculates expected family contribution.
CAPITAL MARKETS
Retirement Saving.
The Department of Labor proposed a rule which would require retirement plan providers to abide by enhanced fiduciary standards, under the definition laid out by the Employee Retirement Security Act. Investment advisors who put profit before people “can result in reduced returns and higher costs which are junk fees that chip away at many Americans’ savings,” wrote the Department. “Analysis of just one investment product–fixed index annuities–suggests that conflicted advice could cost savers up to $5 billion per year for this product alone.”
AFR and other members of the Save Our Retirement coalition applaud the proposed rule, calling it a “banner day for retirement savers” if it turns out as strong as the groups urged.
Buybacks.
Earlier this year, the SEC issued a much-needed, if limited, rule to promote transparency by requiring public companies disclose new information about their stock buybacks, including why they happened. Now, the conservative Fifth Circuit Court of Appeals – the same that sided with the predatory payday lending lobby in CFSA v. CFPB – has sided with a Chamber of Commerce lawsuit and has required the agency to consider the business lobby’s comments to revise the rule.
Disaggregation.
AFR-EF supports a proposal from the Financial Accounting Standards Board to require public companies to disaggregate certain costs from expense captions, with particular attention toward disaggregating employee compensation costs. The move increases transparency, helping make income statements more useful to investors.
Conflicts of Interest.
In January, the SEC issued a rule to prohibit conflicts of interest in the sale of asset-backed securities. A bipartisan group of House representatives claimed the rule would make it more difficult for families, “already enduring both a credit crunch and a housing crisis…to make ends meet.” They suggest that it would “significantly curtail participation in the securitization market” and hurt the availability of financing.
Journalists + Investors = ?
Apparently, an idea for a new trading firm. A team of financial journalists and investors plan to create a firm “designed to trade on market-moving news unearthed by its own investigative reporting,” reports FT. The plan: they’d perform their investigation, place trades based on their findings, then publish the articles and trading thesis. They won’t trade on information that wasn’t publicly available, they claim.
Empowering Main Street?
Senate Banking’s Scott is assembling a bill called the Empowering Main Street in America Act, which purports to do a lot for “Main Street” – promoting capital formation for small businesses, expanding opportunities for retail investors and increasing market transparency. But it also strikes at what Scott calls an “increasingly hostile regulatory environment” by increasing oversight on the SEC. The Act would call on Gensler to testify on semiannually and require the agency to perform “thorough rulemaking cost-benefit analysis.”
PRIVATE MARKETS
Financial Engineering in Hospitals.
An essay adapted from The Big Fail: What the Pandemic Revealed about Who America Protects and Who It Leaves Behind, a recent book by two prominent financial journalists, Joe Nocera and Bethany McLean, reveals how private equity’s “financial engineering” destroys hospitals. In Riverton, Wyoming, the PE megafirm Apollo scooped up the local hospital SageWest in a $5.6bn purchase of the healthcare chain LifePoint Health. Even before the firm came in, LifePoint had combined SageWest with a hospital thirty minutes away with the intent to split specialties between the two. When ownership fell to Apollo, however, rather than perform the split and strengthen what services remained at each branch, “hospital managers were simply stripping away essential services from their community.” With difficult roads to traverse in winter, WSJ found that the number of ambulance airlifts out of the country grew six times over from 2014 to 2019.
The authors call Riverton’s case a “snapshot of the turmoil that has engulfed the hospital sector” since private equity started its purchasing incursion. Over a decade ago, seven of the largest for-profit chains were owned by PE, and their ownership is often accompanied by slashing essential services, staffing shortages, higher prices, greater debt burdens and in one case a threat to close up shop if they didn’t receive taxpayer money during the pandemic.
Related: A Connecticut news nonprofit examines the decline of a local hospital, Rockville, after it was purchased by Prospect Medical. Private equity firm Leonard Green & Partners owned a majority stake in Prospect for a decade before it sold it off in 2021, five years after the chain bought Rockville.
Firm Fraud.
Two private equity firms, H.I.G. Capital and Audax Group, are at odds in the Delaware court system in a case that could peel back the “corporate veil” which PE firms often use to hide from their own wrongdoing. This week, the former firm sued the latter, accusing it of “brazen, massive, systemic fraud” after the two sealed a $915mn deal for equity in a telecom software company. The complaint alleges that Audax artificially inflated financial information, “including via the creation of a quasi-shell ‘customer’” of the company, Axios reports.
High Rates.
“The firms that used the era of cheap money to become the new financial titans are wrestling with rising interest costs,” FT reports, as “default rates are picking up and lenders are increasingly taking control of creditor companies at the expense of equity owners,” and exit activity has dried up. With less money coming in, they’ve been turning to financial engineering schemes to pay dividends, such as borrowing heavily against their combined assets or turning away from making interest payments in cash.
SolarWinds Lawsuit
The SEC charged SolarWinds and its chief information security officer with “fraud and internal control failures relating to allegedly known cybersecurity risks and vulnerabilities.” According to the formal complaint, from its IPO in Oct. 2018 to at least Dec. 2020, the company was the target of a nearly two-year long cyberattack called “SUNBURST.” But the company “defrauded investors by overstating SolarWinds’ cybersecurity practices” and failing to disclose known risks. Reminders: two private equity owners of SolarWinds sold shares of the company days before the hack was revealed and a lawsuit alleged their squeeze on the company led to the hack.
Endowment Money at Risk.
Besides pension funds and sovereign wealth funds, another class of institutions that invest in private equity are universities, allocating large portions of their endowments to private funds. By FY2022, 18% of endowment assets were in PE holdings – 30%, if venture capital investments are included. According to a report from Moody’s Investors Service, investing in private equity funds expose colleges to increased credit risk, as “Private equity holdings can be opaque and difficult to assess, and returns can diverge materially from public markets, potentially leading some university investment committees to underestimate the related risks or overstate expected returns.”
Other PE News.
Devouring the Economy. The Atlantic explains the Secretive Industry Devouring the U.S. Economy. Hint: It’s private equity, which “has made one-fifth of the market effectively invisible to investors, the media, and regulators.”
Election Betting. Kalshi, the gambling platform that lets people bet on just about anything (like the outcome of the affirmative action SCOTUS case, for example), lost its bid to let hedge funds and other investors bet on U.S. elections. Now, it’s suing the CFTC.
The Gulf. More private equity firms have flocked to the Persian Gulf to “deepen their ties with cash-rich sovereign wealth funds and families in the region as funding for buyouts has dried up elsewhere.
CRYPTO
SBF and FTX.
Sam Bankman-Fried, the founder of the collapsed crypto exchange FTX, has been convicted on all seven counts of fraud and conspiracy after a month-long trial. A twelve-person jury found Bankman-Fried guilty of a multibillion dollar fraud scheme to steal customer funds.
SafeMoon.
Federal authorities arrested the CEO, CTO and founder of the digital asset SafeMoon for defrauding investors of tens of millions of dollars to finance luxury purchases. The token, they claimed, would “drive the price to stratospheric all-time highs” and “Safely to the Moon.”
Crypto Accounting.
In May, the SEC posted Staff Accounting Bulletin 121, a rule that guided companies that safeguard consumer crypto assets to mark them as liabilities. This week, the Government Accountability Office sent a letter to the Commission saying the agency needed to have sent it to them first. Politico notes that after the GAO report, “Republicans were quick to issue promises to block SAB 121 in the coming weeks,” as both Republicans and the crypto industry have decried the rule.
HOUSING
Inflated Commissions.
A federal jury found that the National Association of Realtors and two real estate agencies violated antitrust rules to inflate home sale commission rates, reports Politico. They’ll have to pay $1.8bn in damages.
Offices to Homes.
The White House wants to turn more office space into affordable housing and plans to deploy “new financing, technical assistance, and sale of federal properties” to spur the transition. This year, commercial real estate vacancies hit a 30-year high, a report from the Council of Economic Advisers finds, in the same quarter that investment in CRE had fallen 64% year-on-year. Meanwhile, at the end of 2020, the housing market had a deficit of almost four million units, and rental vacancies in the last four years have been at their lowest since the 1980s. In addition to guidance and cashflow toward making the conversion projects themselves viable, the Department of Transportation will focus on developing and rehabilitating transit-related projects.
Weak Mortgage Market.
As high interest rates constrain the performance of the mortgage market, some lenders are trying to claw back the bonuses from ex-employees they hired during the industry’s ultralow boom. “Some former regulators and industry officials say the current period is worse than the 2008 financial crisis,” WSJ reports. Mortgage application activity is at its lowest level in almost 30 years, employment in the space has dropped by a fifth since 2021, and loan officers’ average monthly pay in September was halved compared to three years ago.
Florida’s Insurance.
Florida’s going through an insurance crisis right now, with sky-high premiums driven only higher by extreme weather events intensified by climate change. A Florida senator, already one of the wealthiest in the state, called on his fellow lawmakers to invest in a new homeowners insurance company projecting a 165% return-on-investment over five years.
Related: Only the wealthy are still around to rebuild in Fort Myers Beach, a town destroyed by Hurricane Ian. “As the effects of climate change worsen, taxpayers will increasingly subsidize the costs of beachfront living by the rich, including sea wall construction, beach replenishment and road elevation, as well as sending rescue workers in to save lives in emergencies,” Bloomberg reports.
CLIMATE and FINANCE
Don’t Water Down Climate Disclosure!
House Financial’s Ranking Member Waters advised the SEC’s Gensler to work quickly to finalize a robust version of his agency’s proposed climate disclosure rule. Lately, the Commission has been on the fence about the application of Scope 3, which would require companies to capture information about emissions all throughout their value chain – for example, a gas company would have to include their customers burning their product in their report. Said Waters:
“Given the strong support both from the investor and stakeholder community that demands and would consume these disclosures, and the recent developments in California and by our banking regulators, I urge you to not abandon key components of your proposed rule, including requirements to disclose Scope 3 emissions.”
Insurance Data Collection.
The Treasury will move ahead with a plan to collect “previously unavailable insurance data…from the largest homeowners insurance providers” to better understand how climate-related financial risks impact people across the country. AFR says it’s an important step in the right direction, but expressed disappointment that the plan was scaled back from earlier proposals, and would omit queries that were important in understanding the insurance crisis.
Related: The Senate Budget Committee asked 40 private insurers in California, Louisiana, Florida and Texas to explain how they’ll cover the growing losses from extreme weather. The lawmakers are “increasingly concerned about the potential economic consequences of an eventual widescale decline in property values caused by increasing exposure to climate risks and the attendant increase in insurance premiums and decrease in insurance availability.”
The Climate Fight and the Fed.
Politico suggests that one of the hurdles in Biden’s plan to tackle climate change might be banking regulators. The administration wants to pump federal dollars into renewables with tax credits, but the industry often looks to big lenders to finance their projects. Last year, investors put $19bn toward these projects in exchange for credits and other benefits. The renewables industry and some Democrats worry that incoming Basel III “Endgame” regulations, a crucial slate of rules to shore up banks’ capital buffers to promote financial stability, will make it more difficult for bankings to offer funding.
Oil Refiner Finance.
“If you have the word ‘refinery’ anywhere in your title, you’re not going to get finance,” said the CEO of Malaysia’s Pengerang Energy Complex, remarking on how oil refiners are increasingly hard-pressed to obtain financing from banks. Bloomberg reports that “banks have placed more restrictions on financing oil and gas, with the expectation that the world will soon need less of them.”