What's the Big Deal with the Lawsuit Against the Federal Reserve?

Major US banks, including JPMorgan Chase, Citibank, and Goldman Sachs (or, to be precise, the Bank Policy Institute) are reportedly preparing a lawsuit against the Federal Reserve. This action, unprecedented in recent history, challenges new regulatory measures proposed by the Fed. Led by Eugene Scalia, the lawsuit aims to contest rules requiring banks to maintain higher cash reserves.

The Context

The Federal Reserve has proposed rules necessitating banks to hold an additional 20% in cash reserves. They are designed to fortify the banking sector against liquidity crises and avoid repeats of recent bank failures like that of Silicon Valley Bank. As you might have guessed, the new measures have been met with resistance from major financial institutions. They argue that the actual impact of these rules would require them to keep up to 30% in cash reserves, significantly more than the Fed's estimate.

This potential legal battle is set against the backdrop of the Basel III agreement's final implementation stages. The Basel III rules aim to standardise global banking regulations, a response to the disjointed regulatory landscape that followed the 2008 financial crisis. The resistance from the banks is, well, interesting…

What’s Liquidity?

Banks don’t have all the money they lend on their books. They operate on what is known as the fractional reserve banking system, which allows them to lend out a significant portion of the deposits they receive, keeping only a fraction of these deposits as reserves.

That’s why liquidity is important. Liquidity refers to the ability of a bank to meet its financial obligations, especially short-term ones, without incurring substantial losses. It involves having enough cash or easily convertible-to-cash assets to cover customer withdrawals and other immediate demands for funds. Adequate liquidity is crucial for operations, as it ensures that the bank can fulfill withdrawal requests, respond to unexpected expenses, and participate in new lending opportunities without facing solvency issues. Essentially, it’s about having sufficient resources available to smoothly conduct day-to-day transactions and obligations.

Minimising Risk in Loan Underwriting

Banks employ rigorous risk assessment and compliance measures to minimise the underwriting of bad loans. RegTechs play a crucial role in enhancing these efforts. They automate compliance tasks and help to ensure adherence to regulatory standards, reducing the likelihood of default. There's been a lot of buzz around AI recently but this is one of the most tangible use cases. AI algorithms (ML & NLP) can analyse vast amounts of data to predict loan repayment probabilities, identifying potential risks more accurately. The recent advancements with LLMs help with things like document analysis. Technology, combined with traditional risk assessment methods, enables banks to make more informed lending decisions and maintain financial stability.

Importance of the Lawsuit

This is a big deal. Many specialists see the legal challenge as a critical moment in the relationship between the financial sector and regulatory bodies. The lawsuit could set a precedent, influencing future regulatory approaches and the balance between financial stability and economic growth.

Arguments from the Banking Sector

Banks are raising concerns that these heightened reserve requirements would restrict their lending capabilities, affecting small businesses and lower-income borrowers, and impacting their profitability and shareholder commitments. This is basically eating into their profits, pushing them in some lines of business to make decisions they don’t want to take, i.e., pulling back from lending. There’s tension between regulatory measures aimed at ensuring financial stability and the banks' need to remain profitable and competitive.

Considerations in Light of SVB's Collapse

The recent collapse of Silicon Valley Bank underscores the potential risks of inadequate capital reserves in the banking system. It highlights the necessity of having the right safeguards in place to prevent bank runs and ensure financial stability. This context makes the Federal Reserve's proposed rules appear prudent and necessary for the broader health of the financial system.

Conclusion

It’s all about balance. The outcome of this potential lawsuit could influence the future of banking regulation, affecting the global financial system as a whole. It underscores the ongoing challenge of balancing the need for financial stability with the constant push for growth. The outcome will likely have long-lasting implications. Thinking about opportunities, technology (RegTech in particular) will have a significant role and I foresee more partnerships between banks and FinTechs to enhance their abilities to write better loans and make more informed credit and risk decisions.

References

Basel III: International Regulatory Framework for Banks (2017) The Bank for International Settlements. Available at: https://www.bis.org/bcbs/basel3.htm (Accessed: 31 January 2024).?

Hoffman, L. (2024) Big Banks Mull the unthinkable: Suing the Fed, Semafor. Available at: https://www.semafor.com/article/01/11/2024/big-banks-mull-the-unthinkable-suing-the-fed (Accessed: 31 January 2024).

Lotmore, M. (2024) Major US Banks considering legal action against federal regulators, Lynnwood Times. Available at: https://lynnwoodtimes.com/2024/01/30/capital-requirements-240130/ (Accessed: 31 January 2024).

Mirmoeini, F. (2023) How automation and AI are revolutionizing Regtech efforts, RTInsights. Available at: https://www.rtinsights.com/the-future-of-regulatory-technology-regtech-how-automation-and-ai-are-revolutionizing-compliance-efforts/ (Accessed: 31 January 2024).

Wasowski, G. (2023) What is a bank run?, LinkedIn. Available at: https://www.dhirubhai.net/pulse/what-bank-run-greg-wasowski/ (Accessed: 01 February 2024).

Wasowski, G. (2024) How to build a value-driving AI strategy for your business, Aquiva Labs Blog. Available at: https://aquivalabs.com/blog/how-to-build-a-value-driving-ai-strategy-for-your-business (Accessed: 31 January 2024).?