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As genius acts move relentlessly towards legislation, US banks may be under more pressure to do business with Stablecoin issuers and cryptocurrency companies. However, this could create new regulatory issues for them. The Federal Reserve, like most global supervisors, has always included a measure of “reputation risk” in its risk assessment. The risk of doing any business can attract unfavourable publicity and lead to damage to business franchises or, in the worst case, banking operations.
How does the bank intend to deal with the post-Genius world?
By taking leaves from Joan Jett’s songbook, the Fed appears to be trying to solve their problems.
This week, the Fed distributed a revised version of its assessment risk management guidelines, in which all mentions of reputational risk are removed. Officially, this is seen as a too subjective issue, as banks are acquired by the personal judgment of careful supervisors regarding legal business with legitimate clients despite working well in all other aspects of risk management.
Nevertheless, Crypto is taking it as a big win for Crypto. In their world, it was viewed as unfair that the Fed’s reputation risk scores were sometimes used as an excuse to “bank off” crypto companies. The FDIC and OCC are taking similar steps.
Of course, it’s not going to be a ignoring risk. As the Signature Bank failure report reveals, if you have a very easy-to-run responsibility structure based on plane wealth management deposits, anything that you get negative headlines can turn into an existential crisis pretty quickly.
The Fed’s guidelines remind banks that they need to manage all business risks, while removing reputational risks from their official scores. That includes the risk that lying down with your dog could wake you up with fleas.
And it might be a little worse than that. As the Basel Committee’s guidance on the supervisory review process reminds us, it’s not just that bad publicity is a concern for supervisors about reputational risk. The fear of bad publicity is often the fact that good bankers do stupid things. In particular, bankers have the awful habit of throwing good money after bad by bailing out clients and business partners that are intended to be separate entities. Reputation risk is one of the precursors of “step-in risk.”
In other words, if a crypto company is loaned to a bank with the highest quality Wall Street name and starts to avoid it by saying it will attract customers based on that evidence, then if the crypto company gets into trouble, those customers turn their eyes to their Wall Street partners and become a whole. And the bank may do so to maintain its reputation and long-term business franchise, or to “stop corruption” and stop contagious panic.
Supervisors dislike this practice. It caused great losses during the 2008 financial crisis. Because it turns out that the banks were not good at determining the size of the black holes they had promised to meet.
More generally, it breaks the relationship between published balance sheets, supervisor returns, and actual risks to capital. However, it is extremely difficult to eliminate, especially since it is often difficult to distinguish between the risk of a bad kind of step-in, from rescue operations that supervisors often want to organize themselves.
Now, US authorities have decided they are not going to ask anyone to systematically track the types of companies maintained by regulated banks. It all feels like “what could possibly be wrong” right?
