Acting Comptroller Suggests Some Banks Are "In the Penumbra" of Being Too Big to Manage
Plus, more regulatory discussion from earnings calls
Too Big to Manage
Today Acting Comptroller of the Currency Michael Hsu delivered remarks at a gathering held by the Brookings Institution to discuss whether some large banks have become too big to manage.
The Acting Comptroller’s verdict? Possibly!
There are limits to an organization’s manageability. Based on my experience as a bank supervisor and as Acting Comptroller of the Currency, I believe there is a growing body of evidence to support this premise. Enterprises can become so big and complex that control failures, risk management breakdowns, and negative surprises occur too frequently – not because of weak management, but because of the sheer size and complexity of the organization. In short, effective management is not infinitely scalable.
If a bank does grow to such size, a bank might try one or more of changing its management, adopting remediation plans, or devoting large sums of money to risk and control improvements, including by hiring additional personnel. The problem Acting Comptroller Hsu sees with those measures, though, is that all of them “will have limited impact” if the bank is already too big to manage.
Therefore, the Acting Comptroller laid out a four-step escalation framework the OCC will use for determining whether a bank under its supervision has grown too big to manage and, if so, what to do about it.
A bank will first be put on notice of deficiencies or weaknesses through non-public supervisory actions.
If significant deficiencies or weaknesses persist, the OCC will bring a public enforcement action, such as a consent order, perhaps paired with a civil money penalty.
If, even after being subject to the public enforcement action, weaknesses persist, then “the public perception can be that the bank either does not care enough to fix the problem,” seeing the enforcement action as merely the cost of doing business, “that the bank is not capable of fixing the problem, or both.”
The framing here is kind of odd - shouldn’t this be less about what the public thinks and more about what the OCC thinks? In any case, the OCC would at this stage believe that restrictions on “growth, business activities, capital actions” or some combination thereof would be necessary to force management to take the issue more seriously or to serve as a compensating control until the issue is fixed.
These steps would not be imposed lightly. According to Acting Comptroller Hsu triggers could be “repeat offenses, repeated delays in meeting established remediation milestones, or new violations of similar laws or regulations.”
If, even after all that, the bank “continues to violate the law or drags out remediation timelines,” then the OCC will look to break up the bank by requiring divestitures. If this stage is reached, the OCC believes the divestiture strategies that large banks have already identified as part of the resolution planning process will provide the OCC with actionable options.
How Should the Public Interpret All This?
We probably differ on what we think the next steps ought to be, but credit to Sarah Pray of Americans for Financial Reform for asking what I thought was the most direct question of the session.1
Other regulators have obviously taken steps recently clamping down on Wells Fargo in particular as one of the most egregious repeat offenders in this field, and I was wondering if you could talk a little bit more about what is new here. Not specific to Wells, but that we could apply to a bank that is clearly too big to manage, that has demonstrated a flagrant disregard for regulators all over the government, and that from our perspective needs to be fast tracked on that framework that you laid out today.
Acting Comptroller Hsu did not explicitly take the bait on Wells Fargo. He did offer the following, however, which I think is fair to read as saying, yes, this should be interpreted as a shot across the bow to that firm, and potentially to other banks.
… Another way to ask the question is who is the audience for this. There are going to be some banks that are in the penumbra of being too big to manage and because of that this escalation framework has a lot of salience - where are they in terms of that escalation process and articulating where we are in how we are thinking about it and what we are willing and going to do when we hit those [garbled].
The other population are large banks that are growing and expanding rapidly that aren’t there. … Again, I’ll go back - prevention is key. If we are dealing with a too big to manage bank, it’s too late, we’ve done something wrong. … So a lot of these signs I put out are for bank senior management, bank boards of directors, supervisors, to say hey, these are signs that something needs to happen. And usually what needs to happen is, slow down. …
What’s Next?
Overall it was a pretty direct speech, admirably short of the vagueness to which public speeches about bank supervision sometimes lend themselves. At the end, though, a few reliable generalities did get trotted out. For instance, Acting Comptroller Hsu referenced the need to strike a balance, to appropriately take due process considerations into account, and to closely coordinate with interagency stakeholders.
Unobjectionable stuff, but it does it leave it unclear what will come next, and how quickly. All Acting Comptroller Hsu would say is that the OCC is “considering steps to provide greater transparency and predictability” in connection with the above.
Earnings Regulatory Round Up (Part 2)
Today also featured earnings announcements and conference calls from Goldman Sachs, Morgan Stanley and several others. As with last Friday’s post, this post briefly rounds up the notable regulatory-related discussion from the announcements or calls.2
Goldman G-SIB Surcharge
This year Goldman Sachs’s G-SIB surcharge is 3%, up from 2.5% last year. In Q3 filings, Goldman had warned that its 2024 surcharge could wind up being higher still, depending on how 2022 shook out.
Our G-SIB surcharge is 2.5% for 2022 and 3.0% for 2023. Based on financial data for 2021 and the nine months ended September 2022, we are above the threshold for the 3.5% G-SIB surcharge.
In that same filing, though, the firm also said there was a chance it would be able to manage its year-end 2022 balance sheet (the only one in 2022 that counts for purposes of calculating the 2024 surcharge) to avoid that outcome.
Based on the recent operating environment and our clients’ needs, we are currently targeting to be at the 3.0% G-SIB level as of December 2022 (which would be effective for our January 2024 G-SIB surcharge). Our ability to achieve the 3.0% G-SIB level will depend on the market environment and needs of our clients in the fourth quarter of 2022.
The market environment in the fourth quarter could fairly be characterized as lousy - David Solomon led off the earnings call by calling Goldman’s financial results “disappointing” and “not what we aspire to deliver to shareholders.”
As it relates to the above the rough environment did have one potential upside, however, as Solomon also explained in his introductory remarks:
Specifically, we reduced the size of our balance sheet, further optimized and reduced our RWA footprint and manage[d] down our G-SIB score to hit our 3% target.
Goldman RWAs
Speaking of Goldman’s RWA footprint, the materials released this morning included the following footnote.
In the third quarter of 2022, based on regulatory feedback, the firm revised certain interpretations of the Capital Rules underlying the calculation of Standardized RWAs and Advanced RWAs. As of December 31, 2021, this change would have increased both Standardized RWAs and Advanced RWAs by approximately $6 billion to $683 billion and $654 billion, respectively. These increases would have reduced the firm’s Standardized CET1 capital ratio of 14.2% by 0.1 percentage points and advanced CET1 capital ratio of 14.9% by 0.2 percentage points.
Put more plainly, what happened here is that the Federal Reserve Board informed Goldman that the firm was not assigning the correct risk weights to certain exposures. The revisions described today were not the first time this has happened. From Goldman’s 10-K filed this past February:
In the third quarter of 2021, based on regulatory feedback, the firm revised certain interpretations of the Capital Rules underlying the calculation of Standardized RWAs. As of December 2020, this change would have increased the firm’s Standardized RWAs of $554 billion by approximately $23 billion, which would have reduced the firm’s Standardized CET1 capital ratio of 14.7% by 0.6 percentage points, Standardized Tier 1 capital ratio of 16.7% by 0.6 percentage points and Standardized Total capital ratio of 19.5% by 0.8 percentage points.
As always, there is no claim here that this is scandalous - the capital rules are hard, and it is not crazy to sometimes reach a different interpretation of them than that reached by your regulator.
Instead, I mention this because I doubt Goldman is the only firm at which this has happened recently. In its November 2021 Supervision and Regulation report, the Board said that one of its supervisory priorities for large financial institutions was to conduct “reviews of risk-weighted assets under the capital rule.”
Newtek Declines to Discuss Its OCC Operating Agreement
Newtek Business Services Corp., soon to be renamed NewtekOne, until recently operated as a business development company. In early January, however, Newtek completed its acquisition of the National Bank of New York City, withdrew its BDC election, and became a financial holding company regulated by the Federal Reserve Board.3
This is very much not tax or any other sort of advice, but as I understand it a BDC is required to pay out at least 90% of its net income in the form of dividends. A key question for Newtek investors, then, is how Newtek’s dividend plans will change now that it is a bank holding company supervised by the Federal Reserve Board and now that it owns a bank subject to OCC supervision.
In earlier press releases, Newtek has said that subject to “compliance with regulatory requirements and Newtek achieving its operational and financial goals, it anticipates that Newtek will continue to pay dividends as a bank holding company.”
Newtek also separately disclosed, however, that as a condition to the OCC’s approval of its bank acquisition, it had been required to enter into an operating agreement with the OCC that “contains customary provisions concerning capital, liquidity and concentration limits and memorializes the business plan submitted to the OCC.”4
On today’s earnings call, an analyst asked whether that operating agreement might hamper Newtek’s dividend plans.
Bradley Rinschler: Okay. And there was just one question. I've never seen this before in your -- when you guys announced that you got the regulatory approval. The OCC approval is subject to the condition that Newtek Bank entered into an operating agreement with the OCC upon the close of the acquisition. Can you speak to that a little bit about what that is or just kind of explain a little bit because we've never seen that, that there's an operating agreement post getting regulatory approval. Any type of color there would be great.
Barry R. Sloane: Yes. I would say just in generalities, obviously, I can't discuss with regulatory agreement. But when we apply, we put certain forecast, projections, capitalization ratios in that. And I would say that putting aside what you just said, we've agreed to operate on that basis. Okay.
Bradley Rinschler: Okay. So it doesn't have any type of stipulations like with growth or dividends or anything like that?
Barry R. Sloane: I think what — so I'm trying not to answer your question. However, here's what I can answer. What we put out into the market today is consistent with we believe is totally in compliance with both, the OCC and the Fed. Yes. I've been asked at times, do you have different sets of projections for different people? [indiscernible] I said no.
I don’t think the characterization by the analyst of this as unusual in connection with this sort of acquisition is completely correct - for example, both LendingClub and SoFi were required by the OCC to enter into (non-public) operating agreements when they acquired national banks.
The analyst is right to wonder, though, whether that operating agreement includes anything that could limit Newtek’s ability to pay a dividend. It does for LendingClub, for example.5 I guess the best way to read Newtek in the quote above is as saying the answer is, “not materially,” but it is tough to say for sure.
Two Banks Burned By Crypto Provide an Update
Today Signature Bank management explained that what the crypto space needs is more regulation.
Joseph Depaolo: … What this ecosystem needs is regulation. We need to be able to function where the economy is confident. Having this FTX situation clearly put a lack of confidence in that ecosystem. Now what we need to do is to get regulation, get confidence back in the system and we can go from there. It occurs to a lot of people that when you do innovation, you always -- in the initial part of the innovation, there's always looked upon, initially down upon. And that's what I think is the situation here.
They later clarified that this does not necessarily need to be regulation of Signature Bank, of course.
Matthew Breese: … my last one is just love your thoughts on the crypto regulatory front and implications to you, particularly on the back of the interagency guidance earlier this month. I'm curious in the wake of FTX if there's been any reassessment on the institutional client book or the BSA, AML, KYC process front to make sure that there aren't other instances of fraudulent activity? What changes, actions have you taken? And what kind of comfort can you give us on the quality of the remaining client book?
Joseph Depaolo: Well, I'll say this with FTX, it wasn't a matter of BSA, AML. Everyone thought that he was -- resume it [?] and he ended up being very [Madoff-like]. So I don't think anyone could say that they knew that and we [didn’t] catch it.
When we're talking about regulation is we just want to know which way you go because we had Signet and we try to make enhancements on it, and some of it are okay by the regulators and some were not. It puts us in a difficult position as to what we do -- what do we do next, and not knowing regulation-wise, what's going to happen puts us really behind everyone else that is the crypto world. …
There's no -- I think what happens is when the regulations come out, that will eliminate a number of players. I don't know if -- actors, but I would say a number of players couldn't live up to the regulation, whether it's capital related or just doing AML, BSA. But again, FTX was not a BMA, AML. It was a Bernie [Madoff] like a situation that no one really thought that Sam was a bad asset.
Silvergate Bank also endured its own earnings call today on which analysts sought management’s take on the Bernie Madoff explanation offered by Signature as quoted above. Silvergate offered a firm no comment.
Steven Alexopoulos: Okay. Thanks, Tony. And then for my follow-up, I don't know if you guys heard the Signature call this morning, but in the Q&A session, they had a question on AML/BSA. And they indicated that for FTX it was more of a [Madoff] situation. They specifically said not an AML/BSA issue. Do you guys see this the same way as it relates to Silvergate, not an AML/BSA concern?
Alan Lane: Yes. Steve, unfortunately, I did not get a chance to listen to the Signature call, so I don't have the context for how they referenced it. But, we're just not going to comment at all on any kind of FTX related matters. And so, from my perspective, we should just focus on our core business and all of the things that we're doing to help this ecosystem, and let all that other stuff kind of work its way out.
Also today Silvergate disclosed that its and its bank’s Tier 1 leverage ratios had come down significantly, from above 10% to just a bit over 5%. (To be clear, this is still just fine from a regulatory perspective, but it is maybe a bit too close to the 5% bank well-capitalized threshold for comfort.)
This led analysts to ask whether a capital raise might be in order. Management didn’t answer directly, but did say that they think the decline is not quite so stark as it looks.
Jared Shaw: I guess looking at capital, especially Tier 1 leverage took obviously a big move down. You commented in the opening comments about rebuilding that organically. Is that organic growth rate going to be enough to satisfy your expectations or need for Tier 1 leverage in terms of trying to get closer to a double-digit Tier 1 leverage ratio, or should we think that there may have to be some additional capital raising or other alternatives looking at?
[…]
Tony Martino: Yes. Thanks, Alan. Thanks for the question, Jared. So, yes, as Alan mentioned, that -- the Tier 1 leverage ratio that we disclosed, 5.36, it's based on average assets approximately $15 billion, as I mentioned in my prepared remarks. But the balance sheet ended at $11.3 billion. So, on a pro forma basis with the Tier 1 capital that we had at year end, that would imply an entry point above 7%. And then, with the further guidance of -- or subsequent event disclosure that we've sold down $1.5 billion in securities to reduce wholesale funding, that implies a further reduction. So, that's kind of step one in terms of the organic path of rebuilding the Tier 1 leverage ratio.
Tomorrow’s Post
Unfortunately the Board and OCC orders approving BMO’s acquisition of Bank of the West came too late to include a discussion in this already long post. A more detailed analysis will follow tomorrow morning, along with a few scattered observations on the Board’s climate scenario analysis release.
Pray also separately asked Acting Comptroller Hsu a second good question about what he sees as the next steps in the agencies’ review of the bank merger process. Acting Comptroller Hsu made a pitch for the OCC’s upcoming bank merger symposium but didn’t share details about future plans beyond that.
All quotes are taken either from transcripts prepared by S&P Capital IQ and available via MarketScreener or from Seeking Alpha.
I am focusing the discussion here on the OCC approval and its conditions, but some readers may be interested to note as well that according to a different 8-K filed by Newtek the Federal Reserve Board has determined that certain of its activities are not permissible under the Bank Holding Company Act: “[A]s a result of commitments made to the Federal Reserve, the Company will divest or otherwise terminate the activities conducted by Excel WebSolutions, LLC and Newtek Technology Solutions, Inc., including its subsidiary SIDCO, LLC d/b/a/ Cloud Nine Services, within two years of becoming a financial holding company, subject to any extension of the two-year period.”
The OCC recently made available its order approving the Newtek transaction, but the public version of the order does not include any specifics about what is or is not included in the operating agreement.
As noted, LendingClub’s operating agreement is not public. In SEC filings, however, the company has said that its operating agreement with the OCC requires it to “obtain a prior written determination of non-objection from the OCC before declaring any dividend.”