Karen Petrou: Why the Fed’s New-Found Neglect of Banks is Not Benign
Clients will today receive our in-depth analysis of the Fed’s proposal to radically realign access to the nation’s payment system. As we make clear, the Fed is eyeing a change many banks fear will put them at an acute competitive disadvantage. Ordinarily, this would slow the central bank. Now, not a bit, a sea-change from longstanding Fed thinking. If it lasts, banking will never be the same.
Is that all to the good? In the request for input on new payment accounts, the Fed says the following about what it has taken considered formulating these “skinny” payment accounts:
[T]he Board has considered the risks identified in the Guidelines (i.e., risks to the Reserve Banks, to the overall payment system, to financial stability, to the overall economy as a result of illicit activities, and to the implementation of monetary policy. In addition, the Board considered features that could limit Payment Accounts’ impact on the Federal Reserve’s balance sheet.
Did the Board just forget about banks? I don’t think so. Arguably, only captive regulators work to protect their charges from market forces. Market efficiency is enhanced if uncompetitive banks seek to clog the rails for low-cost, high-innovation services.
Or so it would be if this were a fair fight, which it isn’t. Banks are of course under an extensive – some might say crippling – set of prudential standards designed in part to ensure clearing-and-settlement capability. They are also key to financial intermediation. As we noted last week, a new FRB-NY study shows that old-school retail banks are the most important banks when it comes to robust, resilient economic growth. If their ability to provide payment services is impeded thanks to regulatory arbitrage, then intermediation takes a hit that will be felt quickly in the economy as a whole.
The Fed’s newfound focus on market discipline […]
Karen Petrou: Why Big-Bank Compensation is No Longer Impregnable
I and many others have noted over the years that populists and progressives often advocate the same economic policies no matter how much they otherwise wage culture wars. A little-noticed case in point is work underway in the Trump White House to subject the biggest defense contractors to strict limits on compensation and capital distributions. Treasury Secretary Bessent is said to support the idea, leading Sen. Warren to suggest a “partnership.” Might this extend from prime defense contractors to GSIBs? It’s unlikely, but not impossible.
The rationale for the prime-contractor constraints is frustration over the decades in which these firms have consolidated and gotten ever bigger contracts yet delivered fewer and fewer armaments on time anywhere close to on budget. There is thus a flood of stories about how many ships, planes, and super-weapons the Chinese build as U.S. capabilities grow ever older, slower, and still more expensive. Will de facto nationalization for defense contractors make the U.S. military agile again because contractors grow hungry? I don’t know the sector well enough to even hazard an answer.
But, I do know a bit about banking. Would similar comp constraints lead GSIBs to slim down as Secretary Bessent desires? Maybe, but the power would shift not to smaller banks, but to the biggest nonbanks sure to lure disenchanted GSIB executives to the still-lucrative spheres of private credit and so many other bank-like activities. I doubt Mr. Bessent wants this, but the real deciding factor over GSIB comp limits isn’t substantive; it’s political.
I can safely say that the President will not scruple at slamming GSIBs if he is persuaded that this will appeal to his base, which it may at a particularly convenient moment. Indeed, the President might not need a midterm-election objective to slap GSIBs around. All it might take […]
Karen Petrou: Policy Now Demands that Bankers Back Pornographers – What could Go Wrong?
As we noted, the OCC last week loosed an anti-debanking fusillade at nine of the nation’s biggest banks. Among other things, the agency sanctions banks for deciding on customers based on “values” and for evaluating relationships affected by negative press coverage. The OCC demands that key business sectors be served without scruple even if, as with “adult entertainment,” there may be good reasons to demur. Some “adult entertainment” may be legal, but much isn’t and even that which is legal may still be reprehensible. Must a bank owned by devout Christians still lend to support activities it believes to be sinful? Should it do so, its community is likely to abhor the bank, unaware of the OCC’s policy as it rallies against the bank in righteous rage. To meet the OCC’s edict and still adhere to risk-management policies, would banks need to ensure – God knows how – that no performers were trafficked and the most vile scenes were all made with images, not children? Can the OCC in fact order banks to eschew values, subjective business judgment, and political opinion? I think and hope not.
We’ve been in such a debanking frenzy that a fundamental examination of what it means has never been overtly undertaken by those demanding an end to it. Most Members of Congress are rightly moving cautiously with a focus largely on ending “reputation risk” reviews, while banks reasonably point to Obama and Biden era no-banking orders to show that the fault lies not with them, but with Administrations gone by. The Trump Administration strongly agrees with this assessment – see our report on the prayerful CFPB meeting last week appealing both to the heavens and law enforcement for remedy. However, blanket anti-debanking demands may well smother not just sound banking, but also a bank’s […]
Karen Petrou: Tether’s Tangled Web of High-Risk Assets
Last week, the IMF said that stablecoins could prove a threat to financial stability if widespread adoption is followed by a sudden consumer-confidence shock. A little-noticed report makes it clear that any consumer with confidence in the largest USD-denominated stablecoin, Tether, is betting on fumes and policy-makers touting widespread adoption are playing with fire. As the IMF rightly says, stablecoins may well have valuable use cases, but radical reform is essential for innovation without immolation.
The Tether report comes from S&P, a rating agency with an unfortunate habit of pointing to problems only after they’ve become irreversible and irrefutable. Since its report on Tether was unsolicited, perhaps it’s more objective than many others and thus the early warning the agencies promise, giving markets a chance to retrench and regulators to rethink.
S&P’s report looks at the critical question of whether Tether can convert its dollar-denominated coins into dollars on demand. The GENIUS Act attempts to ensure this with what it hopes are stringent reserve-asset requirements. S&P makes it all too clear that the El Salvador-domiciled issuer has a long, long way to go before it can meet even these requirements.
Since its last rating, S&P has now downgraded Tether to “weak.” This is because the percentage of assets housed in higher-risk and/or volatile sectors actually increased. For example, bitcoin alone accounts for about 5.6 percent of Tether’s reserves, up substantially, with a mix of crypto and high-risk assets now accounting for 24 percent of Tether’s total reserves. Notably, none of its reserve assets is segregated from corporate funds, with S&P bewailing opacity also when it comes to accounting, counterparties, custodians, and pretty much anything else that matters.
According to S&P, Tether’s most recent report also shows $174.4 billion in outstanding dollar-denominated stablecoins. That’s a lot, meaning it will be no small feat for […]
Karen Petrou: What Happens if Bank Deposits Follow Assets Out the Door?
Last week, Treasury Under-Secretary McKernan outlined a critical strategic phenomenon: the growing transformation of bank deposits into financial instruments lacking the sticky permanence or taxpayer backstops that characterize core deposits. Does the financial system need bank deposits, or could it do as well with other liabilities or even representations of liabilities? This question signals, Mr. McKernan said, a policy transformation warranting attention in the most senior quarters, not just among “technocrats.” He’s right, and here’s why.
As the American Banker rightly pointed out last week, analysis here must carefully differentiate tokenized deposits from deposit tokens. Tokenized deposits are deposits, albeit with additional functionality. Deposit tokens – the transformational alternative – are tokens with deposit features that are only deposits in practice, depending on confidence that others will accept the tokens as either a medium of exchange or store of value. Deposit tokens are thus private money and, if they work as an alternative to central-bank money, pose an even more profound strategic challenge to banking as we know it than all of the NBFIs gobbling up traditional bank assets.
Quite simply, deposits are the lifeblood of banking. Could deposit tokens prove to be the vampires that transform legacy banks before tokenized deposits mount a meaningful defense?
Stablecoins are the nearest concern because they are clearly deposit tokens and perhaps front of Mr. McKernan’s mind since Congress blessed them as a new monetary instrument. Stablecoins are of course digital representations of “money” exchanged on a blockchain that are intended to handle payments as seamlessly as bank deposits moving through the traditional payment system. Under new U.S. law, each token represents a dollar’s worth of other, dollar-denominated assets. These “reserve assets” are supposed to secure the deposit token’s redemption value, but there are many reasons to question how well this works under stress. […]
Karen Petrou: The Fed’s Secret Safety Net for Cayman Island Hedge Funds
In a speech last week, Secretary Bessent described Treasury obligations as “not only the bedrock of the global financial system, but also the American dream.” So they are, but they are also a huge source of profit to basis-trading hedge funds happily evading U.S. taxes in the Cayman Islands. Should the Fed grow its already-gargantuan portfolio at still more taxpayer risk and expense just to keep the good times rolling? Are there no better ways to ensure Treasury-market stability without a Fed portfolio so large that, as Secretary Bessent has also said, it makes America ever less equal? There are indeed better ways and the Fed should deploy them, not just comfort the morally hazardous with still another backstop.
An October Federal Reserve study finds that a longstanding source of FRB systemic-risk worries —basis trading hedge funds — is dramatically under-counted in conventional Treasury-market data sources. Cayman Island-domiciled hedge funds are now, the Fed data show, the largest foreign holders of Treasuries with $1.85 trillion as of the end of 2024 – a trillion-dollar run-up in just two years. Their holdings now eclipse those of each of China, Japan, and the U.K. who are otherwise the largest foreign holders. Only the Federal Reserve holds more Treasury obligations than all these hedge funds in the tax-free sun.
At the same time, short-term rates continue to show significant signs of stress surely worsened by the fact that leveraged basis-traders borrow repos without posting lending to net out most of the risk. FRB officials at last week’s Treasury-market conference were thus at pains to say not only that the central bank will resume buying Treasuries as the FOMC promised, but do what it takes to ensure that the Fed’s portfolio is funded by bank reserves that are at least “ample,” if not […]