Public Funds Investment Institute

More on Bank Capital Rules:  The Fed Chair Speaks

March 12, 2024
image 6

If you were the CEO of one of the nation’s largest banks you might say that the most significant element of last week’s monetary policy report to Congress by  Federal Reserve chair Jerome Powell was not about interest rates—“When will you cut them?”—or the state of the economy—“Are we in  a recession or not?” Rather it was a few words in the chair’s colloquy with members of Congress about the much-debated Basel III End Game rules.

Recall that the rules were proposed by federal bank regulators last year as they continue to address systemic stresses that nearly caused the collapse of the world’s financial system in 2008-9. They would impose new risk-based capital requirements on the nation’s 37 largest banks. 

 The furious industry lobbying around the proposed rules seems to have paid off, as in his testimony last week Powell said in response to several questions by members of Congress that he could see “broad and material” changes to the proposal. At one point he allowed that it was “very plausible” that the rules could be withdrawn entirely.

This must have been music to the ears of the CEOs of the eight largest banks which have built up a large capital cushion in anticipation. According to Bloomberg this total $154 billion of excess capital could be returned to shareholders if the rules were scrapped entirely.

image 5

Recall that the rules proposal rose to prominence on the crest of the bank crisis last spring, though a capital shortfall doesn’t seem to have been the major cause of the failures of Silicon Valley Bank and several others.

Nor does insufficient capital seem to be behind the trouble that has beset the New York Community Bank on the anniversary of the Silicon Valley Bank failure. (Though the commitment of $1 billion of added capital and installation of a new CEO seems to have avoided NYCB becoming a 2024 bank failure.)

At its core, the problem the regulators seek to address is one of management that makes, or fails to make, key decisions. The consequences then ricochet through the financial system. Capital may not prevent  a bank crisis, but it provides a buffer against losses that might otherwise  fall on the overall economy or on the Federal government if it were to step in to support the financial system, as it  did in 2009, and again in the Covid-19 market freeze.

Capital rules, or more precisely the rules that specify how much capital should be required for bank business segments such as lending, custody, underwriting, and market making, will be a major factor in determining the way these segments operate and consequently what it costs investors to access the financial markets.

And Powell’s comments on the proposed rules, while not making headlines, could be far more consequential in the long run than the next Fed decision on interest rates.

 The T+1 Initiative

While we’re behind the headlines, it’s worth visiting another initiative aimed at reducing the risk of a market crisis, the so-called T+1 Initiative. May 28, 2024, is the date for implementing these shortened security settlement procedures. By doing so regulators aim to reduce the market’s dependence on trust—and credit.

Public funds investors, who deal largely in Treasury and Federal Agency debt and money market instruments like commercial paper, are already accommodated to short trade/settlement windows (since these securities generally settle on the same day that they trade), but the T+1 Initiative, which will apply to corporate and municipal bonds, among other security types, presents a reason to  review  procedures for policy compliance, internal approvals, communicating with broker/dealers and custodian banks, and the risks associated with these procedures.  (There is a guide to T+1 settlement published by the Depository Trust and Clearing Corporation (DTCC) here.

The background:   Most investors don’t give it much thought, but in reality, buying or selling securities involves two steps.  In the first, the parties agree to terms (which security is involved, what its price is and what account will buy or sell it). This happens on the “trade date.”  In the second step the security and money are exchanged. This is on the “settle date.” 

In theory, trade and settlement could happen simultaneously (and blockchain technology might facilitate this) but in practice they do not. During the window that separates them the parties, while bound by agreement (a contract in legal terms), are exposed to performance risk—that is, the risk that one party will fail to do its part to complete the transaction. If the risk is systemic (let’s say a broker/dealer suddenly closes its doors and all of its obligations fail) then the broader financial system could be impacted. (Widespread failures to settle securities could "freeze" the markets.)

Once upon a time, when securities existed in physical form engraved on paper, when you bought  a security you would agree to the terms of the purchase (price, total dollar value, etc.) then someone would mail the security to you or your custodian bank or, more likely in the institutional market, put it in a locked brief case, handcuff the briefcase to the wrist of a courier, and send the courier through the streets of Manhattan to your bank where they would present the bond and receive a bank draft payable in immediate cash for the agreed price. This involved a fair amount of logistics, and the convention was to allow for five business days between trade and settlement (T+5).

As the overall volume and magnituide of financial transactions grew, it became apparent that systemic risks were magnified by the time interval between trading and settling a security.  Technology and operational changes—and regulator pressure—collapsed T+5 to T+3 days (in 1993), T+2 (in 2017) and finanlly to the current initiative to shrink the period of expsure to one day, beginning on May 28.

This is all about reducing the period when the contract for the purchase/sale of bonds remains open in order to reduce  risk of performance and risk that coordinated or related failures could disrupt the broader financial markets.

The bottom line: Technology can help in compressing the time needed to go from trade to settlement.  Straight through processing of trade orders can route them directly from the broker to the custodian bank—but it should not be a substitute for your reviewing,  reconciling and approving of each transaction.  Technology can also automate real-time investment policy review before and after a trade is agreed to.  And technology can implement real time multiple party internal review/approval of investment transactions.

T+1 also will change the timetable for making cash available to pay for securities,  and the way you to reinvest cash proceeds from investments sold.  Cutoff times for accessing cash from money funds, LGIPs or bank sweep vehicles and for  investing free cash will become even more important as trade and settlement dates converge around T+1

Greetings, fellow colleagues in the public funds investment community! I'm Marty Margolis, a seasoned expert with a deep understanding of the intricacies of managing public sector investments. Having led the growth of PFM Asset Management and managing assets exceeding $150 billion, I am excited to connect with you through the Public Funds Investment Institute. If you haven't already — subscribe below to join our community, explore our thought leadership, and gain valuable insights. I encourage you to connect with me on LinkedIn or reach out via email to share your thoughts, feedback, and ideas. Let's collaborate and make a positive impact together.

Best regards,
Marty Margolis

Stay informed and ahead of market changes – join now.

Just sign up and start receiving our no cost research. “Beyond the News” is our weekly publication and "The Spotlight" is our in-depth analysis.