Things in the News
Single-counterparty credit limits, ESG, Senator Warren's criticism of Acting Comptroller Hsu, and what's up with Protego?
This post discusses a few things in the news this week where my thoughts were too long for Twitter but too short (or too half-baked) for a standalone post.
More 10-Ks
Last weekend I wrote the first in what is intended to be a series of posts looking at new or notable disclosures in large bank 10-Ks. So far there have not been many additional filings this week (most banks will not file until next week or the week after), but two updates in State Street’s 10-K filed on Thursday are worth briefly noting.1
The same disclaimer from last weekend applies: The disclosures are being discussed here simply because I think they are interesting, and not because they are necessarily material.
Single-Counterparty Credit Limits
The large exposures framework is a Basel Committee standard that requires banking organizations to limit their exposures to a single counterparty or group of connected counterparties. Permitted exposures are capped at a percentage of regulatory capital.
In the United States, the large exposures framework has been implemented in connection with the Federal Reserve Board’s adoption of rules under Section 165(e) of the Dodd-Frank Act.2 The Board refers to this regulation as the single-counterparty credit limits rule, or SCCL.
Under the SCCL final rule, a U.S. global systemically important bank holding company may not have aggregate net credit exposures to any single other G-SIB (U.S. or foreign) if such aggregate net credit exposure exceeds 15 percent of Tier 1 capital.3
In an updated disclosure in this year’s 10-K, State Street explains one way in which this rule can matter for large custody banks:
[T]o the extent we maintain currencies on our consolidated balance sheet (where the client deposit liability is with State Street and State Street, as principal, maintains cash on deposit with a subcustodian or clearing agency) or are subject to regulatory requirements to return assets placed in custody, we are also subject to the risk of credit exposure to such subcustodians and clearing agencies. […]
If the subcustodian or clearing agency were to become insolvent in circumstances not involving expropriation of assets or other circumstances that excuse performance under force majeure or other provisions, the risk of loss on such cash on deposit would be ours rather than the clients.
As of December 31, 2022, we held cash on deposit with our subcustodian and clearing agencies in Russia, which amount is expected to increase substantially over time as long as the sanctions and other restrictions remain in effect, and which currently is subject to restrictions on our ability to access such deposits.
What makes this particularly tricky is that the companies State Street engages as subcustodians (and thus to which it may have a credit exposure) are, per the 10-K, “also directly or subsidiaries of large global, financial institutions with whom we have other credit exposures.”
Accordingly, according to State Street’s updated disclosure, compliance with the SCCL rule has been made “more challenging.”
That is all the detail that is provided, so it is not clear exactly how challenging things have been. Also unclear is whether something in addition to Russia's invasion of Ukraine happened in 2022 that prompted this new disclosure4 -- the SCCL rule took effect for banks like State Street at the start of 2020 and there was no equivalent detailed discussion in prior year 10-Ks -- or whether this information is intended to be more general.
State Street is the first large U.S. custody bank to report this 10-K, so it is also not yet clear if its peers also encountered similar SCCL challenges last year.5
ESG and Indexing Concerns
State Street’s 10-K also includes a new risk factor about “political and regulatory scrutiny of ESG investing practices.” None of this is all that surprising, but I figured it worthy of brief mention here as an addition to some of the ESG-related disclosures highlighted last weekend.
The new risk factor says, in essence, that some people think ESG is very bad, while others think it is very good, and both of those views could wind up posing risks to State Street. A sample:
Our Investment Management line of business provides investment management strategies and products that incorporate consideration of ESG factors into the investment decision-making process. […] In connection with these activities, we have also become members of various organizations (e.g., Climate Action 100+, Net Zero Asset Managers Initiative) focused on climate change and other ESG issues.
These ESG-related investment management practices have recently become the subject of significant scrutiny by regulatory agencies and government officials. Certain officials have suggested that ESG-related investing practices may result in violations of law – including antitrust laws – and breaches of fiduciary duty. Views on ESG practices, particularly those related to climate issues, have also become political issues, which can amplify the reputational risks associated with such allegations. […]
We also face potential risks presented by the adoption of proposed rules currently under consideration by the SEC, which would impose new disclosure requirements and naming conventions for ESG-related funds and other ESG-related disclosure obligations on public companies more generally. "Greenwashing" regulations in other jurisdictions could have similar effects. Governmental enforcement action could also spark civil litigation claims by clients and fund shareholders asserting violations of law, fiduciary duties and contractual obligations.
The risk factor also includes at the end a brief nod to some of the anti-indexing arguments that have gained traction among both left and right.
As a general matter, large index providers, such as State Street Global Advisors, have been and are expected to continue to be subject to legislative and regulatory proposals or investigations from both sides of the political spectrum due to a perception that they exert inappropriate influence over publicly traded companies.
Senator Warren’s Criticism of Acting Comptroller Hsu
In 2016, Senator Elizabeth Warren went to the Open Markets Institute and delivered a speech that, according to a later description by the Open Markets Institute, was a “pivotal” address that “put antitrust enforcement and competition policy back on the political map” and “helped spur policymakers into action.”
This week Senator Warren returned to the Open Markets Institute and sadly reported that, despite her best efforts, some policymakers have not been sufficiently spurred into action.
Banking is another example. The Federal Reserve, OCC, and FDIC all have special tools to stop bad bank mergers under the Bank Merger Act. They just keep letting banks get bigger and bigger. Just a few months ago, the Fed and the OCC let U.S. Bank, the fifth-largest bank in the nation, grow even larger by swallowing up a smaller rival. Since 2006, the Fed has received over 3,500 bank merger applications, and they haven’t stopped a single one. Not one.
So far pretty standard. But Senator Warren then singled out one regulator by name:
C’mon, guys. Who are you working for? OCC Acting Comptroller Hsu needs to learn to say no to anticompetitive bank mergers. Comptroller Hsu should also start preparing the banking industry for change by advancing new bank merger guidelines.
This is not the first time this has happened. In October shortly after the U.S. Bank transaction was approved, Senator Warren sent a tweet calling out the OCC (and only the OCC).
Progressives have a long history, sometimes justified, of being concerned about the actions of the OCC, and Senator Warren is not alone in making the Acting Comptroller a focus of her criticisms. I also admit that I have my own previously acknowledged biases here, in that I think current bank merger policy is basically fine, and so may not be able to fairly evaluate Senator Warren’s claims on the merits.
But even acknowledging all that, isn’t Senator Warren’s criticism of Acting Comptroller Hsu awfully convenient? The OCC is not the only regulator that had to approve the large 2022 or 2023 mergers with which Senator Warren takes issue. As Senator Warren's speech briefly acknowledges, the Federal Reserve Board approved them as well.6 And it did so unanimously. Twice.
More to the point, in each case four of the seven total votes from the Board of Governors in favor of the mergers in question came from persons who Senator Warren had only months earlier voted to put on the Board.7 Unlike Acting Comptroller Hsu, none of those persons are mentioned by name.
Given my admission earlier that I do not share most of Senator Warren’s concerns about bank mergers, I realize I may not be the most credible person to make this point. Indeed, I think it is a good thing that Senator Warren did not vote against these otherwise qualified nominees on the basis of a purity test related to bank mergers. But if Senator Warren really has the degree of concern with federal bank merger policy that she professes to have (“a serious risk to the entire financial system”), why has this not been reflected in Senator Warren’s voting record on nominations, and why the continued focus on just one person?
Checking in (Again) on Protego
Per Nic Carter, Operation Choke Point 2.0 Is Underway, And Crypto Is In Its Crosshairs. Overall I find this characterization a bit inflammatory, but it is definitely true that there have been a number of high profile enforcement actions recently, and it is also true that a number of banks are, through some combination of their own volition and encouragement from their regulators, becoming warier of ties to crypto.
Among other things, this has led Carter and others to suggest that Paxos and Protego, each of which were conditionally granted national bank charters by the OCC in 2021, are unlikely to be given final approval by the OCC and thus will not be allowed to open for business. Carter says:
As of Feb. 8, Protego and Paxos’ applications to follow Anchorage and obtain full approval to become National Trust Banks are still outstanding (past the 18 month deadline), and appear likely to be imminently denied by the OCC
In a February 8 article in Fortune, Leo Schwartz looked into these rumors and reported that both companies deny having heard this from the OCC.
Several industry participants, with varying (but confidently high) levels of confidence, told Fortune on the condition of anonymity that the OCC had followed suit and asked Paxos and Protego to withdraw their applications—an act that would send shockwaves through the industry, by dashing the crypto-focused financial institutions plans to become federally regulated entities.
The rumor has spread widely in the crypto industry, but both Paxos and Protego denied to Fortune that they had received any communication of the sort from the OCC.
Schwartz’s reporting also appeared to have solved (sort of) the mystery of what had happened with the standard 18-month deadline that the OCC had given Protego to open, but then had never mentioned publicly since. Per a statement given to Schwartz by a Protego executive, the deadline has now been extended to the end of February.
Protego’s founder and executive chair Greg Gilman described [the rumor] as “categorically untrue,” although he did add that Protego’s new deadline for approval from the OCC was coming up at the end of February.
The Fortune article is ten days old at this point, and given how fast things are moving it is tough to know what all has shifted since then, but the reason I bring it up here is that the Wall Street Journal has now in two separate articles about crypto this week included its own brief summary of where Protego stands.
Meanwhile, two companies trying to win banking licenses have been left in limbo after winning preliminary approval in early 2021 from the Office of the Comptroller of the Currency. Paxos National Trust and Protego Trust Co. applied to start banks that would custody crypto assets and facilitate trading. Protego’s conditional charter expired recently. The company believes the agency’s increasingly anti-crypto stance played a role in it not yet getting full approval, according to people familiar with the matter.
Paxos National Trust and Protego Trust Co. applied to start banks that would hold crypto assets for clients and facilitate trading. Protego’s conditional charter expired recently. Paxos said in a statement on Twitter that it continues to “work constructively with the OCC.”
It is not clear to me if Fortune and the Journal are reporting the same thing, and simply describing it differently - i.e., Protego’s conditional charter “expired” in the sense that the 18 months ran out (last year) but that the deadline has since been extended8 - or whether even this is in dispute, and two different credible publications are reporting two different things about when the conditional approval expires (or expired).
I suppose the bottom line is that, as has been the case for a while now, no one will really know anything until the OCC itself sees fit to provide an update.
Traditionally the Friday afternoon before a long holiday weekend is the time a banking regulator would regard as perfect for releasing something like this,9 but I have thought that about a few similar Fridays in the past and have come up empty.
Thanks for reading! Thoughts, challenges, criticisms are always welcome at bankregblog@gmail.com
Citizens Financial Group filed its 10-K on Friday morning, but on a first read nothing new or different stood out to me.
The Board’s SCCL rules apply to large U.S. holding companies and to certain foreign banks operating in the United States. Separate from the Board’s rule, bank subsidiaries of such firms are subject to lending limits imposed by the OCC or by their state regulator which existed even before the Basel standard.
State Street is a U.S. G-SIB and I am focusing here on the limit with regard to exposures to other G-SIBs. To be more complete about what the U.S. rule says:
U.S. G-SIBs may have aggregate net credit exposure to a single U.S. or foreign G-SIB counterparty (or a nonbank SIFI, but there currently are none) of no more than 15 percent of Tier 1 capital.
U.S. G-SIBs may have aggregate net credit exposure to any other counterparty of no more than 25 percent of Tier 1 capital.
Other firms subject to the U.S. SCCL rule may have aggregate net credit exposure to any counterparty of no more than 25 percent of Tier 1 capital.
For both U.S. G-SIBs and other firms, there is the potential for a 90-day cure period under certain circumstances.
In addition to the text quoted above, State Street also includes the following in Note 1 to its financial statements.
Sanctions programs or government intervention may inhibit our ability to access cash and due from banks in certain accounts. For example, as of December 31, 2022, we held such accounts in Russia, inclusive of $767 million with our subcustodian, which is an affiliate of a large multinational bank, and with western European-based clearing agencies, for a total of approximately $1.3 billion. Cash and due from banks is evaluated as part of our allowance for credits losses
Some facts suggest this may not be a concern only for State Street. In 2016 Northern Trust, another large U.S. custody bank, urged the Board to exclude foreign demand deposits associated with custody services from the credit exposure calculation. The Board rejected this suggestion, saying:
Section 165(e) explicitly provides that “credit exposure” means all extensions of credit including loans, deposits, and lines of credit. The Board may only grant exemptions that are in the public interest and consistent with the purposes of section 165(e) of the Dodd-Frank Act. In light of the plain language of the statute, the Board believes that if a covered company holds deposits at a counterparty, those deposits should be subject to the limits of the final rule and that an exclusion would not be appropriate in these circumstances.
Northern Trust is not a G-SIB and so is subject to the relatively looser 25% of Tier 1 capital limit discussed in footnote 2. Thus, the SCCL rule may not have posed as many challenges for it.
Senator Warren voted in favor of the nominations of Vice Chair Brainard, Vice Chair for Supervision Barr, Governor Cook and Governor Jefferson. Senator Warren also voted in favor of the nomination of FDIC Chair Gruenberg, after his agency had approved, when he was Acting Chair, a piece of the U.S .Bank-MUFG Union Bank deal. See note 6.
This would be consistent with the “not yet getting full approval” phrasing in the earlier WSJ article (emphasis mine) which could be read to suggest that approval is still at least a theoretical possibility.
Also still pending release and another decent candidate for a Friday afternoon disclosure is the public (redacted) version of the Board’s order denying Custodia’s membership application.