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FINRA issues guidance on broker-dealers using generative AI tools
On June 27, FINRA issued Regulatory Notice 24-09 that discussed the implications to broker-dealers in their use of artificial intelligence (AI), including large language models (LLMs) and other generative AI tools. Although FINRA stated that while AI offered broker-dealers opportunities to improve their services and enhance their operational and compliance efficiencies, it also reminded firms that its rules and federal securities laws continue to apply. In discussing use cases, FINRA noted that AI tools can analyze financial data, summarize documents, and assist in investor education, but also raise concerns about accuracy, privacy, bias, and security.
When using these tools, FINRA reminds firms that: (1) they must have appropriate supervisory systems and governance in place, whether those tools are developed in-house or provided by third parties; and (2) they should evaluate AI tools before use to ensure compliance with FINRA rules. FINRA also stated that in some instances, it could issue further guidance for specific use cases. FINRA encouraged firms to seek interpretive guidance where ambiguous rule applications may exist and have ongoing discussions with their Risk Monitoring Analyst.
NYDFS issues guidance insurers regarding discrimination in affordable housing market
On June 24, Gov. Kathy Hochul announced guidance issued by NYDFS in Circular Letter No. 6 (2024) informing insurers and related parties that, under the new Insurance Law § 3462, making coverage decisions based on a property’s status as an affordable housing development or on the amount or source of a tenant’s income will be prohibited. According to the Circular Letter, the recently enacted law came in response to a “hardening” insurance market that has resulted in increased premiums and reduced coverage options for affordable housing developments. Under the law, insurers cannot base decisions such as issuing, renewing, or increasing premiums for policies on whether a property was an affordable housing development or if tenants received government assistance. The guidance noted that “excess line insurers, and the New York Property Insurance Underwriting Association (NYPIUA) must comply with Insurance Law § 3462 and can no longer request information about government-subsidized housing units or tenants paying rent with housing assistance or use this information for underwriting purposes,” and were required to update their insurance applications and underwriting guidelines accordingly. If insurance rates were previously based on these factors, insurers must revise their rates and submit them to NYDFS.
Rhode Island amends and adds provisions to financial institutions code
On June 25, the Governor of Rhode Island signed into law H 7282 (the “Act”) amending certain provisions of the state’s Title 19 on Financial Institutions and adding new consumer protections. Among other things, the amendments to the Act (i) updated the term “Federal Office of Thrift Supervision” to “Federal Reserve System,” (ii) clarified that the term “Tangible net worth” meant “the aggregate assets of a licensee excluding all intangible assets, less liabilities” in accordance with GAAP, and (iii) increased the minimum capital requirements for currency transmission licensees. The Act further restricted student loan servicers from withholding student transcripts from delinquent borrowers, removed a provision allowing deposit of securities in lieu of bonds, and added provisions on permissible investments for licensees, including cash, certificates of deposit, obligations of the United States, letters of credit with stipulations, or surety bonds.
Ohio allows dual capacity in real estate transactions
Recently, the Ohio Division of Financial Institutions released a letter to repeal prior guidance banning mortgage professionals from acting as both a mortgage professional and a real estate agent in the same transaction. This “dual capacity” was originally banned in the Divisions Mortgage Brokers & Lenders Letter 2006-1 to prevent conflicts of interest that might arise when a single person would both complete a sale and obtain financing for that sale. After the repeal, the Ohio Division of Financial Institutions required licensed mortgage loan originators to disclose when they or an associate will act as a realtor in connection with a property’s sale and to inform and obtain a signature from the buyer. Signatures can be obtained on the Dual Capacity Disclosure Form.
Court grants $12 million final judgment but denies prejudgment interest in RICO class action
On June 18, the U.S. District Court for the Southern District of California entered an order granting plaintiffs’ motion for entry of final judgment against a large for-profit educational institution that has since gone bankrupt. According to the 2020 complaint, plaintiffs were left with debt for what they claimed to be a worthless education. After the school’s bankruptcy in 2016, plaintiffs alleged that they continue to be victimized by defendants’ student loan operation. Plaintiffs filed the motion following a jury trial where defendants were found liable under the Racketeer Influenced and Corrupt Organizations Act (RICO). The jury awarded plaintiffs $4 million in compensatory damages, which was trebled to $12 million under the RICO statute.
In addition to the judgment, plaintiffs applied for an additional $4 million in prejudgment interest. In denying the application for prejudgment interest, the court declined to award the discretionary interest based on allegations that defendants “repeatedly attempted to pick off the class representatives for the very purpose of eliminating this action, or at the very least, delaying it.” The court recognized that defendants’ tactics may have delayed the litigation but did not find them to be unreasonable or unfair to a degree that would warrant prejudgment interest, noting that the plaintiffs’ own post-trial motions contributed to the delay in judgment.
The court entered final judgment against the defendants in the amount of $12 million, with attorneys’ fees and costs to be determined later.
District Court approves $3.65 mil. settlement against student loan servicer
On June 24, the U.S. District Court for the Western District of Pennsylvania approved a class action settlement involving student loan borrowers brought against a student loan servicer. The class alleged that from December 2018 to October 2023, the defendant assessed improperly certain convenience fees to process Perkins loan payments from student borrowers by telephone, IVR, or over the internet. The settlement fund of $3.65 million represents 25 percent of the total processing fees collected from hundreds of thousands of borrowers over roughly five years. The parties agreed that, in the event any funds remain after the first distribution, a second distribution will be made to class members.
Colorado’s DIDMCA opt-out blocked by preliminary injunction
On June 18, U.S. District Court of the District of Colorado granted a motion for preliminary injunction filed by several financial services trade associations, enjoining Colorado from enforcing Colo. Rev. Stat. § 5-13-106 with respect to any loan made by the plaintiffs’ members, to the extent the loan is not “made in” Colorado. As previously covered by InfoBytes, the enjoined provision, contained in Section 3 of Colorado HB 23-1229 and scheduled to become effective on July 1, opted Colorado out of Section 521 of the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) which allowed state-chartered banks to export rates of their home state across state borders. Trade groups sued before this law went into effect (covered here), with the FDIC writing a brief in support of the Colorado Attorney General (here).
The court’s decision turned on its interpretation of DIDMCA Section 525, which allowed states to enact laws opting loans “made in” the enacting state out of Section 521, the provision granting insured state banks the same rate exportation authority as national banks. In support of their motion, the plaintiff trade associations argued that loans to Colorado residents by insured state banks located in other states were “made in” the bank’s home state or the state where key loan-making functions occur. Colorado disagreed, contending that a loan was “made in” both the borrower’s state and the state where the lender is located for purposes of applying the DIDMCA opt out provision.
In granting the preliminary injunction, the court found the argument that only a bank “makes” a loan was “more consistent both with the ordinary colloquial understanding of who ‘makes’ a loan, and, more importantly, with how the words ‘make’ and ‘made’ are used consistently throughout the text of the Federal Deposit Insurance Act, including the [DIDMCA] amendments.” The court explained that “the answer to the question of where a loan is ‘made’ depended on the location of the bank, and where the bank takes certain actions, but not on the location of the borrower who ‘obtains’ or ‘receives’ the loan.” Although the court noted that agency interpretations did not address directly how to apply Section 525 of DIDMCA, it found that “[t]o the extent the agency interpretations are helpful, they support the conclusion that in common parlance, a loan is ‘made’ by a bank and therefore where the bank is located and performs its loan-making functions” (italics omitted).
Colorado has 30 days to appeal the district court’s decision to the Tenth Circuit.
OCC report outlines key risks in the federal banking system
On June 18, the OCC published its Semiannual Risk Perspective for Spring 2024, a report assessing the health and risks of the federal banking system focusing on threats to the safety and soundness of banks and their compliance with applicable laws and regulations. In its release about the report, the OCC stated that the banking system remains sound, but recognized potential consumer difficulties due to a slowing labor market, high interest rates, and “sticky” inflation. The report encouraged financial institutions to improve continuously risk management processes, stating that it was “crucial that banks establish an appropriate risk culture that identifies potential risk, particularly before times of stress.” The information in the report was based on data up to December 31, 2023, and included a special topic, operating environment, bank performance, and trends in key risks.
According to the report, key risk themes included:
- Credit Risk: There was an increase in credit risk, particularly in the commercial real estate sector. The office sector and some multifamily properties were under stress from higher interest rates and structural changes. Loans in these sectors, especially interest-only loans due for refinancing in the next three years, pose a heightened risk.
- Market Risk: Banks were experiencing pressure on net interest margins due to deposit competition, which “may be nearing a peak.” There were challenges in risk management from potential future interest rate changes and unpredictable depositor behavior. The use of wholesale funding was growing, though more slowly, and banks face elevated unrealized losses in their investment portfolios, despite improvements.
- Operational Risk: The operational risk was high due to the evolving nature of the banking environment and cyber threats, including ransomware, were a continued threat. Digitalization and the adoption of new products and services, along with third-party engagement, increased complexities and risks. Fraud incidents and the importance of fraud risk management were also emphasized.
- Compliance Risk: Banks must navigate a dynamic environment with evolving customer preferences, and compliance risk management frameworks need to be adequate and adaptable to changes in banks' risk profiles. Fraud remained a significant risk, with check and wire fraud, and peer-to-peer transaction scams becoming more common. The OCC will continue to evaluate banks' CRA performance.
The report emphasized that these risks can be interrelated, noting that a “stress event could manifest through operational and/or financial events and have institution-specific or sector-wide impacts,” and that “[e]ach stress event may vary (e.g., operational, liquidity, credit, compliance, and other) and resiliency implications need to be proactively considered.”
OCC’s Liang discusses bank vulnerabilities and floats policies
On June 24, the U.S. Under Secretary for Domestic Finance, Nellie Liang, delivered a speech at the 2024 OCC Bank Research Symposium addressing depositor behavior, bank liquidity, and run risk. Liang discussed the spring 2023 bank runs that led to exposures in financial vulnerabilities, and highlighted how technologies and social media “amplified” these vulnerabilities as depositors withdrew their monies rapidly. When discussing the evolution of the banking model, Liang shared that, despite the spring 2023 events, deposits have steadily grown relative to GDP over the past 40 years, displaying banks’ continued benefit to provide liquidity services. Nonetheless, loans and credit lines to non-bank financial intermediaries (NBFIs) have increased.
Among other things, Liang stressed the need for supervisors and regulators to effectively monitor core vulnerabilities, like those that were the “key drivers” of recent runs and called for banks to have the operational capacity to borrow from the discount window. She further highlighted the need to increase transparency of Federal Home Loan Bank (FHLB) practices, noted how the proposal for pre-positioned collateral requirements at the discount window was promising, but raised ultimately questions regarding the type and amount of collateral required, and raised the need to re-examine deposit insurance coverage.
New York Fed releases paper on nonbanks reliance on banks
On June 20, the New York Fed released an article highlighting a recent study that revealed nonbank financial institutions (NBFIs) growth was reliant on banks for funding and liquidity insurance. The article observed that while this relationship between banks and NBFIs may result in overall growth and a wider access to financial services, it could add risks seen during financial strains like the 2007-2008 financial crisis and the Covid-19 pandemic. In response to these stressful periods, NBFIs have turned to banks, and later government agencies, for liquidity. And because the asset holdings of banks and NBFIs have become similar, any forced asset sales by NBFIs could trigger a chain reaction leading to market disruptions. According to the authors of the study, a holistic approach to the bank-NBFI relationship will be necessary to manage systemic risk and maintain financial stability.