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Fed governor weighs tokenization and AI
On April 20, Federal Reserve Governor Christopher J. Waller spoke on innovation and the future of finance during remarks at the Global Interdependence Center. Commenting that “[i]nnovation is a double-edged sword, with costs and benefits, and different effects on different groups of people,” Waller stressed the importance of considering whether innovation is creating new efficiencies and helping to mitigate risks and increase financial inclusion or whether it is creating new or exacerbating existing risks. Waller’s remarks focused on two specific areas of innovation that he believes may have the potential to deliver substantial benefits to the banking industry: tokenization and artificial intelligence (AI).
With respect to tokenization and tokenized assets, Waller flagged several advantages to innovations in this space that use blockchain over traditional transaction approaches, including (i) being able to offer faster or “even near-real time transfers,” which can, among other things, give parties precise control over settlement times and reduce liquidity risks; and (ii) “smart contract” functionalities, which can help mitigate settlement and counterparty credit risks by constructing and executing transactions based on the meeting of specified conditions. He acknowledged, however, that both innovations introduce risks, including potential cyber vulnerabilities and other risks.
Waller also addressed the banking industry’s use of AI to increase the range of marketing possibilities, expand customer service applications, monitor fraud, and refine credit underwriting processes and analysis, but cautioned that AI also presents “novel risks,” as these models rely on high volumes of data, which can complicate efforts to detect problems or biases in datasets. There is also the “black box” problem where it becomes difficult to explain how outputs are derived, where even AI developers have difficulty understanding exactly how the AI technology approach works, Waller stated. “All of these innovations will have their champions, who make claims about how their innovation will change the world; and I think it’s important to view such claims critically,” Waller said. “But it’s equally important to challenge the doubters, who insist that these innovations are much ado about nothing, or that they will end in disaster.”
FSOC seeks feedback on risk framework, nonbank determinations
On April 21, the Financial Stability Oversight Council (FSOC) released a proposed analytic framework for financial stability risks, “intended to provide greater transparency to the public about how [FSOC] identifies, assesses, and addresses potential risks to financial stability, regardless of whether the risk stems from activities or firms.” FSOC explained in a fact sheet that the proposed framework would not impose any obligations on any entity, but is instead designed to provide guidance on how FSOC expects to perform certain duties. This includes: (i) identifying potential risks covering a broad range of asset classes, institutions, and activities, including new and evolving financial products and practices as well as developments affecting financial resiliency such as cybersecurity and climate-related financial risks; (ii) assessing certain vulnerabilities that most commonly contribute to financial stability risk and considering how adverse effects stemming from these risks could be transmitted to financial markets/market participants, including what impact this can have on the financial system; and (iii) responding to potential risks to U.S. financial stability, which may involve interagency coordination and information sharing, recommendations to financial regulators or Congress, nonbank financial company determinations, and designations relating to financial market utility/payment, clearing, and settlement activities that are, or are likely to become, systemically important.
The same day, FSOC also released for public comment proposed interpretive guidance relating to procedures for designating systemically important nonbank financial companies for Federal Reserve supervision and enhanced prudential standards. (See also FSOC fact sheet here.) The guidance would revise and update previous guidance from 2019, and “is intended to enhance [FSOC’s] ability to address risks to financial stability, provide transparency to the public, and ensure a rigorous and clear designation process.” FSOC explained that the proposed guidance would include a two-stage evaluation and analysis process for making a designation, during which time companies under review would engage in significant communication with FSOC and be provided an opportunity to request a hearing, among other things. Designated companies will be subject to annual reevaluations and may have their designations rescinded should FSOC determine that the company no longer meets the statutory standards for designation.
Comments on both proposals are due 60 days after publication in the Federal Register.
Both CFPB Director Rohit Chopra and OCC acting Comptroller Michael J. Hsu issued statements supporting the issuance of the proposed interpretive guidance. Chopra commented that, if finalized, the proposed guidance “will create a clear path for the FSOC to identify and designate systemically important nonbank financial institutions” and “will accelerate efforts to identify potential shadow banks to be candidates for designation.” Hsu also noted that sharing additional details to improve the balance and transparency of FSOC’s work “would both make it easier for [FSOC] to explain its analysis of potential risks and create an opportunity for richer public input on the analysis.”
Fed governor outlines CBDC risks
On April 18, Federal Reserve Governor Michelle W. Bowman cautioned that the risks of creating a U.S. central bank digital currency (CBDC) may outweigh the benefits for consumers. Bowman said the Fed continues to engage in exploratory work to understand how a CBDC could potentially improve payment speeds or better financial inclusion, and noted that the agency is also trying to understand how new potential forms of money like CBDCs and other digital assets could play a larger role in the economy. In prepared remarks delivered before Georgetown University’s McDonough School of Business Psaros Center for Financial Markets and Policy, Bowman raised several policy considerations relating to privacy, interoperability and innovation, and the potential for “unintended effects” on the banking system should a CBDC be adopted. She also commented that due to the upcoming rollout of the agency’s FedNow Service in July (covered by InfoBytes here), real-time retail payments will happen without the introduction of a CBDC. With respect to privacy, Bowman cautioned that any CBDC “must ensure consumer data privacy protections embedded in today’s payment systems continue and are extended into future systems.” She added that “[i]n thinking about the implications of CBDC and privacy, we must also consider the central role that money plays in our daily lives, and the risk that a CBDC would provide not only a window into, but potentially an impediment to, the freedom Americans enjoy in choosing how money and resources are used and invested.”
Hsu says OCC focused on fairness in banking
On March 30, acting Comptroller of the Currency Michael J. Hsu commented that the safety and soundness of the federal banking system continues to be a top agency priority, as is improving fairness in banking. Speaking at a conference, Hsu discussed several measures taken by the OCC to elevate and advance fairness, particularly for the underserved and financially vulnerable. Explaining that OCC examiners are encouraging bank management to review existing overdraft protection programs and consider adopting pro-consumer reforms, Hsu referred to CFPB guidance issued last October to address unfair, deceptive, and abusive practices associated with “so-called ‘surprise overdraft’ fees.” (Covered by InfoBytes here.) He also commented that both the Federal Reserve Board and the FDIC have cited the risk of violating UDAP in connection with the certain overdraft practices. Hsu noted that not all overdraft practices are equal, stating that “authorize positive, settle negative” and “representment” fees both present heightened risks.
Recognizing the recent decline in banks’ reliance on overdraft fees, Hsu emphasized that most bankers he has spoken to “understand the importance of treating their customers fairly and have been open to learning about best practices.” He noted that “[t]hese bankers are committed to being there for their customers and providing them with short-term, small dollar liquidity when it is needed most. Many customers tell their banks, as well as groups that have studied overdraft practices, that this banking service helps them meet payments when they come due.” Hsu added that the OCC’s intended goal is to “improve the fairness of these programs by making them more pro-consumer, not to eliminate them,” and that “[m]ore fairness means more financially healthy communities, which means more trust in banking.” Hsu also discussed efforts taken by the OCC to combat discriminatory lending practices, including working to enhance supervisory methods for identifying appraisal discrimination.
Fed to launch FedNow in July
On March 15, the Federal Reserve Board announced a July launch date for its FedNow Service. (Covered by a Special Alert here.) Beginning the first week of April, the Fed will start formally certifying participants, with early adopters completing a customer testing and certification program in preparation for sending live transactions through the system. The certification process “encompasses a comprehensive testing curriculum with defined expectations for operational readiness and network experience,” the Fed explained. “We couldn’t be more excited about the forthcoming FedNow launch, which will enable every participating financial institution, the smallest to the largest and from all corners of the country, to offer a modern instant payment solution,” said Ken Montgomery, First Vice President of the Federal Reserve Bank of Boston and FedNow program executive. “With the launch drawing near, we urge financial institutions and their industry partners to move full steam ahead with preparations to join the FedNow Service,” Montgomery added.
In addition to certifying early adopters for the July launch, the Fed said it will continue to engage with financial institutions and service providers to complete the testing and certification program throughout 2023 and beyond. FedNow “will launch with a robust set of core clearing and settlement functionality and value-added features,” the agency said, explaining that “[m]ore features and enhancements will be added in future releases to continue supporting safety, resiliency and innovation in the industry as the FedNow network expands in the coming years.”
Fed governor says transparency is key for promoting innovation in the banking system
On March 14, Federal Reserve Governor Michelle W. Bowman presented thoughts on innovation trends within the U.S. financial system during a conference held by the Independent Community Bankers of America. Bowman commented that innovation has always been a priority for banks of all sizes and business models, and that regulators—often accused of “being hostile to innovation” within the regulated financial system—are continually trying to learn and adapt to new technologies, which often introduce new risks and vulnerabilities. In order to address these challenges, which are often amplified for community banks, Bowman said banks must be prepared to make improvements to risk management, cybersecurity, and consumer compliance measures, and regulators—playing a complementary role—must ensure rules are clear and transparent. She further stressed that “[i]t is absolutely critical that innovation not distract banks and regulators from the traditional risks that are omnipresent in the business of banking, particularly credit, liquidity, concentration, and interest rate risk.” Noting that these types of risks are present in all bank business models, Bowman said they “can be especially acute for banks engaging in novel activities or exposed to new markets, including crypto-assets.”
Explaining that transparency is important for promoting a safe, sound, and fair banking system, particularly when it comes to innovation, Bowman stated that insufficient clarity or transparency or disproportionately burdensome regulations may “cause new products and services to migrate to the shadow banking system.” Bowman went on to discuss ways bank regulation and supervision can support responsible innovation, and highlighted unique challenges facing smaller banks, as well as key actions taken by regulators to date relating to crypto assets, third-party risk management, cybersecurity, Community Reinvestment Act reform, bank mergers, and overdraft fees, among others.
Fed issues Bank Term Funding Program FAQs
On March 13, the Federal Reserve Board issued FAQs on its Bank Term Funding Program, which launched March 12, to provide additional funding to eligible depository institutions in order to meet depositors’ needs. The program will serve as an additional source of liquidity against high-quality securities, and will eliminate the need for an institution to quickly sell those securities in times of stress. Loans of up to one year in length will be made available to “banks, savings associations, credit unions, and other eligible depository institutions pledging U.S. Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral.” The Fed said in its announcement that it “is closely monitoring conditions across the financial system and is prepared to use its full range of tools to support households and businesses, and will take additional steps as appropriate.”
Republican lawmakers ask about risks of customers’ digital assets on balance sheets
On March 2, Senator Cynthia M. Lummis (R-WY) and Representative Patrick McHenry (R-NC) sent a letter to the Federal Reserve Board, FDIC, OCC, and NCUA requesting input on SEC guidance issued last year that directs cryptocurrency firms to account for customers’ digital assets on their balance sheets. Last April, the SEC issued Staff Accounting Bulletin No. 121 (SAB 121), covering obligations for safeguarding crypto-assets held by entities for platform users. Among other things, SAB 121 clarified that entities should track customer assets as a liability on their balance sheets. “[A]s long as Entity A is responsible for safeguarding the crypto-assets held for its platform users, including maintaining the cryptographic key information necessary to access the crypto-assets, the staff believes that Entity A should present a liability on its balance sheet to reflect its obligation to safeguard the crypto-assets held for its platform users,” SAB 121 explained.
Claiming that SAB 121 “purports to require banks, credit unions and other financial institutions to effectively place digital assets on their balance sheets,” the lawmakers argued that this “would trigger a massive capital charge,” and in turn would likely prevent regulated entities from engaging in digital asset custody. Rather, regulators should encourage regulated financial institutions to offer digital asset services, since they are subject to the highest level of oversight, the letter said. Among other things, the letter asked the regulators whether the SEC contacted them prior to issuing the guidance, and if they have directed regulated financial institutions to comply with SAB 121. The lawmakers also inquired whether the regulators “agree that SAB 121 potentially weakens consumer protection by preventing well-regulated banks, credit unions, and other financial institutions from providing custodial services for digital assets[.]” The letter pointed to the bankruptcy case of a now-defunct crypto lender, which classified all customers as unsecured creditors, as an example of the legal risk of requiring customer custodial assets be placed on an entity’s balance sheet. “SAB 121 places customer assets at greater risk of loss if a custodian becomes insolvent or enters receivership, violating the SEC’s fundamental mission to protect customers,” the lawmakers wrote.
Agencies warn banks of crypto-asset liquidity risks
On February 23, the FDIC, Federal Reserve Board, and OCC released a joint statement addressing bank liquidity risks tied to crypto-assets. The agencies warned that using sources of funding from crypto-asset-related entities may expose banks to elevated liquidity risks “due to the unpredictability of the scale and timing of deposit inflows and outflows.” The agencies addressed concerns related to deposits placed by crypto-asset-related entities for the benefit of end customers where the deposits may be influenced by the customer’s behavior or crypto-asset sector vulnerabilities, rather than the crypto-asset-related entity itself, which is the bank’s direct counterparty. The agencies warned that the “uncertainty and resulting deposit volatility can be exacerbated by end customer confusion related to inaccurate or misleading representations of deposit insurance by a crypto-asset-related entity.” The agencies also addressed issues concerning deposits that constitute stablecoin-related reserves, explaining that the stability of these types of deposits may be dependent on several factors, including the “demand for stablecoins, the confidence of stablecoin holders in the stablecoin arrangement, and the stablecoin issuer’s reserve management practices,” and as such, may “be susceptible to large and rapid outflows stemming from, for example, unanticipated stablecoin redemptions or dislocations in crypto-asset markets.”
The agencies’ statement reminded banking organizations to apply effective risk management controls when handling crypto-related deposits, commensurate with the associated liquidity risk of those deposits. The statement suggested certain effective risk management practices, which include: (i) understanding the direct and indirect drivers of potential deposit behavior to ascertain which deposits are susceptible to volatility; (ii) assessing concentrations or interconnectedness across crypto deposits, as well as the associated liquidity risks; (iii) incorporating liquidity risks or funding volatility into contingency funding planning; and (iv) performing robust due diligence and ongoing monitoring of crypto-asset-related entities that establish deposit accounts to ensure representations about these types of deposit accounts are accurate. The agencies further emphasized that banks are required to comply with applicable laws and regulations, including brokered deposit rules, as applicable, and Call Report filing requirements. The joint statement also reminded banks that they “are neither prohibited nor discouraged from providing banking services to customers of any specific class or type, as permitted by law or regulation.”
As previously covered by InfoBytes, the agencies issued a statement in January highlighting key risks banks should consider when choosing to engage in cryptocurrency-related services.
Fed revises Bank Holding Company Supervision Manual
The Federal Reserve Board recently updated sections of the Bank Holding Company Supervision Manual. (Changes to the manual were last made in November 2021.) The manual provides guidance for conducting inspections of bank holding companies and their nonbank subsidiaries, as well as savings and loan holding companies. “The supervisory objectives of the inspection program are to ascertain whether the financial strength of the bank holding company is being maintained on an ongoing basis and to determine the effects or consequences of transactions between a holding company or its nonbanking subsidiaries and its subsidiary banks,” the Fed explained. Included among the changes are updates to sections on the supervision of savings and loan holdings companies; supervision of holding companies with less than $10 billion in total consolidated assets; liquidity planning and positions applicable to large financial institutions; holding company ratings applicability and inspection frequency; supervision of subsidiaries related to nondeposit investment products; control and ownership of bank holding company formations; asset securitization risk management and internal controls; retail-credit classification; supervision of savings and loan holding companies; and Bank Holding Company Act exemptions. A new section—“Formal Corrective Actions”—revises previous guidance to include entities against which the Fed has statutory authority to take formal enforcement actions. The section also provides additional information on enforcement actions for Bank Secrecy Act and anti-money laundering compliance failures, as well as details on interagency enforcement coordination. The section further clarifies that the Fed “does not issue an enforcement action on the basis of a ‘violation’ of or ‘non-compliance’ with supervisory guidance.” Minor technical changes were made throughout the manual as well. A detailed summary of changes is available here.