Banks are under extreme regulatory assault; it's time to act like it

Vitalii Vodolazskyi - stock.adob

The U.S. banking industry is at war.

The only path to victory is a now-or-never legal strategy.

Instead of nonbank competitors, the industry is under attack from its prudential regulators. They, in turn, are backed by powerful members of Congress, the administration and influential community groups.

Their first attack was the disastrous and ill-conceived Community Reinvestment Act final rule. This 1,500-page dissertational decree is, without a doubt, the most complicated and convoluted regulation in the history of American banking. It is also one of the biggest steps ever toward government credit allocation.

The second attack underway is the proposed Basel capital rule where large banks are apparently being punished for the big bank failures in March 2023, despite the fact that these were caused by negligent supervisors as much as by negligent bankers. The regulators cleverly moved attention away from themselves by using their favorite red herring: demands that banks hold more capital.

The third attack, still in its planning stages, involves proposed liquidity rules. Perhaps our CAMELS-focused regulators finally got the "SLEMAC" memo and hopefully realize the real cause of the March banking madness. Namely, the failure to manage sensitivity to risk and liquidity rather than capital, since all three of those big banks were "well capitalized" (but not well supervised) when they failed.

But why should the regulatory aggressors stop there when there is so much other banking territory to occupy? Why not require underwater securities be marked-to-market through the income statement, like they require banks owning mutual funds holding held-to-maturity CRA bonds?

These recent regulatory assaults, which are separate from those of the Consumer Financial Protection Bureau, Department of Justice or other agencies, have several things in common.

First, they all come out of the mission-creeping Federal Reserve, which has taken on the role of super regulator, with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. acting like cover bands playing Fed music. This is not surprising since both the Treasury secretary and her appointed acting comptroller are former Fed officials.

Second, these attacks are spearheaded by current and former Fed vice chairs. Both hold Ph.D.s and are career academics and policy wonks without real-world banking experience. The only Fed governor with banking experience has courageously opposed these regulatory incursions.

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Third, like so much else today, these are politically based attacks. The Fed's CRA final rule, cloaked as an interagency regulation, was a Biden-supported effort that followed the rescinded June 2020 CRA final rule put forth by Trump-appointed OCC and Treasury officials. Democrats have long criticized Trump's deregulatory efforts in favor of their re-regulatory agenda, always citing any industry crisis, like the March failures, as the result of deregulation.

Fourth, these forays are a blatant attack on capitalism. By expanding the definition of a bank's community to the entire nation, overreaching regulators can now evaluate the social impact of every loan rather than just those made locally around its branches. CRA was meant to stop redlining by ensuring banks lend a reasonable amount back into their local communities where they source deposits. Where they lent the remainder was the bank's business … until now, with the Fed effectively making CRA the "Credit Reallocation Act."

Fifth, rather than celebrate America's unique banking system with a large number of small banks, these incursions, which adopted the international Basel capital standards, will likely encourage more mergers resulting in a small number of large banks like the rest of the world. Our banking system works fine, and its biggest problem today is with the regulators, not the regulated.

Make no mistake, American banking has always been the most heavily regulated industry in the world. Bankers fully understand this, and most do everything they can to play by the rules and hopefully still eke out a profit and serve their communities.

But, what are they supposed to do when over-the-top, politically motivated regulations make it difficult if not impossible to meet their responsibilities to their stockholders and communities?

History and even current events have taught us that the most effective way to deter aggression is to respond in kind, especially when regulatory détente, like pleading to the administration or Congress for relief, has failed.

This means the banking industry, led by the trade groups it finances, must go to court for regulatory justice that will hopefully end with smart fair regulations instead of mindless unfair ones. Community groups went to court over Trump's CRA final rule, and the industry must do the same with Biden's CRA final rule.

No one can predict the outcome of a legal challenge, but I cannot imagine a stronger case against any government regulation than the one banks could mount against the recent CRA final rule. In fact, two trade groups documented a very strong legal case against the proposed rule, and the intended and unintended consequences of the final rule made their good arguments even better.

A successful legal challenge of the CRA final rule should cause the saber-rattling Fed to rethink its proposed capital rule and perhaps back off future regulatory land grabs. It will also let community groups and other critics realize that the industry is doing more than just "shouting about lawsuits."

The industry's failure to legally challenge this obviously unfair CRA rule will make it harder and perhaps impossible to challenge the capital rule. It's an all or nothing legal strategy, and it must begin now.

This is an election year, but it will also be a bank regulatory reckoning year. It is up to the industry to decide if it will capitulate to ill-conceived and unfair regulatory incursions or courageously draw a line in the sand and counter in the courtroom.