Déjà Vu: Model Risks in the Financial Choice Act

Beckwith B. Miller is a Managing Member and Howard R. Sutherland is a Member of the Advisory Board at Ethics Metrics LLC. This post is based on an Ethics Metrics publication by Mr. Miller and Mr. Sutherland. Additional posts on the CHOICE Act are available here.

On June 8, 2017, the Financial Choice Act of 2017 was passed by the House of Representatives, following a CBO analysis dated May 10, 2017. But both the CBO analysis and the House bill fail to address model risks for depository institution holding companies (DIHCs) that date back to 1999 and the creation of large financial holding companies (FHCs) under the Gramm-Leach-Bliley Act.

Those unaddressed model risks reflect material information (MI) that is classified as confidential supervisory information (CSI) by federal bank regulations, and consequently is intentionally omitted from public disclosure for large DIHCs—although it is disclosed for small DIHCs. The result is a bifurcated and inefficient market for large DIHCs (total assets above $10 billion) with low default rates but a highly efficient and brutal market with high default rates for small DIHCs (total assets below $10 billion). Undisclosed MI includes formal enforcement actions (FEAs) targeting violations of safety and soundness, source of strength and the well-managed requirement.

One key aspect of these undisclosed model risks is that intentional omission of material information is a material misstatement according to U.S. securities laws. Ordinarily when a material misstatement exists in DIHC disclosures, auditors must issue a qualified or an adverse opinion rather than a clean opinion. Similarly, DIHC managements are not authorized to certify that internal control over financial reporting (ICFR) is effective when management has knowledge of material misstatements.

Investors in many large DIHCs are thus being misled twice: first by clean audit opinions and management certifications on ICFR that gloss over undisclosed material negative information, and then by management affirmations under SOX that there are no material omissions. Research reveals that the risk profiles of many large DIHCs are identical to those of small DIHCs that did receive and disclose FEAs, concentrating the undisclosed risks in the largest and most systemically significant DIHCs.

An historical analysis of these model risks from 1999 up to May 8, 2017 is provided by Ethics Metrics LLC in our May 27, 2017 post, Federal Banks’ Permitted Concealment of Material Information and Systemic Risk, as well as in Ethic Metrics’ comment letter to the SEC, dated May 8th, 2017, Analysis of Bank Holding Company Disclosures. Ethics Metrics’ comments address unresolved tensions between the SEC and U.S. banking regulators about required DIHC disclosures.

The SEC itself alludes to these tensions on Page 74 of the Commission’s call for comments on its 30-year-old Industry Guide 3, Statistical Disclosure by Bank Holding Companies, to which Ethics Metrics’ May 8th comment letter responds.

Analyzing the Financial Choice Act (FCA) and related CBO analysis in light of these disclosure discrepancies reveals three concerning issues.

First, all of the same model risks remain active, but are not directly recognized by either FCA or the CBO.

Indirectly, the FCA states in:

  • Sec. 151(b) that the Chairman of the Financial Stability Oversight Council will provide confidential briefings to Congressional oversight committees;
  • Sec. 314(b) that regulatory agencies “shall preserve the confidentiality of nonpublic information” as it relates to regulatory analysis;
  • Sec. 536 that a new Office of Independent Examination Review will be created to review examination reports, that “The Director shall keep confidential all meetings with, discussions with, and information provided by financial institutions,” and that “A financial institution shall have the right to obtain an independent review of a material supervisory determination contained in a final report of examination.”
  • Sec. 832 that Congressional committees will have access to confidential information of the Public Company Accounting Oversight Board.The confidential content provided by the federal banking agencies and the PCAOB will include the material information cited above in the model risks.

Second, the FCA repeals the orderly liquidation authority (OLA) for managing the failure of large DIHCs. Our May 26th post, Financial Scholars Oppose Eliminating “Orderly Liquidation Authority” As Crisis-Avoidance Restructuring Backstop, analyzes the consequences of repealing OLA. Providing liquidity during resolution is a key stabilizing factor; that functionality would be eliminated by the FCA for the FDIC in the case of large—and systemically significant—bank failures, as noted below.

Third, the FCA repeals the FDIC’s financial assistance or systemic risk program for large banks under its least cost resolution authority in 12 U.S.C. 1823(c)(4)(G)(i). The FDIC applied this option on November 23, 2008 when it provided financial assistance for the insured depository institutions (IDIs) of a large DIHC, with total assets of $1.3 trillion, that was at risk of default, and again on January 6, 2009 in a similar situation involving the IDIs of a second DIHC with total assets of $1.9 trillion. Neither of the DIHCs had disclosed a FEA during this time even though a liquidity crisis was forcing the FDIC to apply its systemic risk authority to prevent the failure of these firms; the cost of which, with an average loss rate of 19% of total assets, would have approximated $248 billion for the first DIHC and $364 billion for the second DIHC. [See the FDIC’s Historical Statistics on Banking.]

The phrase “too big to fail” places a positive spin on the economics of a fragile U.S. banking system. A rarely discussed limitation on stability support is that the FDIC is subject to a statutory ceiling on the maximum amount of financial obligations it can fund and support through the Deposit Insurance Fund (DIF). The ceiling is called the Maximum Obligation Limitation (MOL), 12 U.S.C. § 1825(c)(5). Components of the MOL include cash, 90% of the fair market value of the assets in the funds, and borrowings from the U.S. Treasury.

As the financial crisis intensified during 2008, the value of the MOL declined from $83.6 billion on 12/31/07 to $69 billion on 12/31/08, according to the FDIC’s Annual Report for 2008. With the FDIC experiencing an average loss rate of 19% of the total assets of the failed IDIs, the maximum funding capacity of the FDIC, in terms of total assets of failed IDIs, as of 12/31/08, was $363 billion ($69 billion/19%).

With the number of bank failures accelerating during each of the calendar quarters of 2008, i.e., 2, 2, 9 and 17, and having access to the confidential supervisory information for all the banks in the country, the FDIC could not afford the failure of one or more of the largest IDIs in the country. The FDIC then applied its authority under 12 U.S.C. 1823(c)(4)(G)(i) to provide financial assistance and thus prevent the failure of the two large DIHCs and their IDIs in late 2008 and early 2009.

On May 9, 2009, Congress (Pub. L. No. 111-22, div. A, title II, 204 (c)) increased the FDIC’s borrowing authority from the U.S. Treasury from $30 billion to $500 billion for 2Q2009 to 4Q2010 so that the FDIC could provide systemic risk financial assistance for IDIs with total assets of $2.6 trillion, assuming an average loss rate of 19% of total assets. The GAO’s report on this event is available at this link.

Repealing the FDIC’s financial assistance or systemic risk program for large banks, as proposed in the FCA, would remove a vital tool for the FDIC in managing the potential failure and related contagion risk of large IDIs and their DIHCs.

Ethics Metrics’ analysis also brings to light the limited financial resources of the FDIC, through its MOL, to fund the failure of IDIs. The FDIC’s current MOL, as of 12/31/16, is $182.1 billion according to the FDIC’s 2016 Annual Report. This means, with an average loss rate of 19% of total assets, the FDIC has a current funding capacity of $955 billion in total assets.

These factors contribute to heightened risks for investors and other stakeholders in large interconnected DIHCs and IDIs.

Page 6 of the CBO analysis states that the “CBO expects that if a systemically important financial firm failed, some federally insured depository institutions would be among its creditors, increasing the probability of losses to the DIF.”

The Federal Reserve’s FR Y-15 Banking Organization Systemic Risk Reports, as of 12/31/16, for 39 systemically important financial institutions (SIFIs), reveals that the SIFIs have:

  • $1.9 trillion of counterparty or intra-financial system investments,
  • issued $4.3 trillion of securities in the market, and
  • $91 trillion of OTC derivatives that are settled bilaterally.

The SIFIs own 72%, or $12 trillion, of the $16 trillion in total U.S. banking industry assets. Four of largest SIFI’s have total assets of $2.4 trillion, $2.1 trillion, $1.9 trillion and $1.7 trillion, each in excess of the FDIC’s funding capacity of $955 billion. In terms of potential contagion risk, registered investment advisers, that are owned by the SIFIs, have also invested approximately $315 billion of equity in about 90 of the largest DIHCs; a market that, as explained above, lacks material information about nearly all of the largest DIHCs. A summary of these exposures is provided at this link.

Additional considerations are that the FSOC’s Office of Financial Research and the PCAOB’s Investor Advisory Group are also eliminated under the FCA. Remaining is the SEC’s Investor Advisory Committee (IAC). Part of the IAC’s purpose is to advise the SEC on issues relating to the effectiveness of disclosure and on initiatives to protect investor interests; to promote investor confidence and the integrity of the securities marketplace.

The focus of the Financial Stability Oversight Council (FSOC) in Sec. 112 of the Dodd Frank Act remains the same, i.e., “to identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace.” Bank holding companies (BHCs) include organizations that are designated as financial holding companies (FHCs) and intermediate holding companies (IHCs). Savings and loan holding companies (SLHCs) have similar but different standards. All of the holding companies are also defined as a DIHC. (emphasis added).

With the repeal of OLA and 12 U.S.C. 1823(c)(4)(G)(i), the U S banking industry would be backed up by only two resources: (1) The FDIC’s current maximum funding capacity of $958 billion. (2) The bank regulatory oversight process that protects the FDIC DIF and the stability of the financial markets—but does not protect investors, including other DIHCs, because it permits large DIHCs not to disclose the foregoing material negative information and related model risks. These, however, are intentional omissions under U.S. securities laws that qualify as material misstatements, as well as leading to qualified audit opinions and ineffective internal control over financial reporting according to SEC and PCAOB laws and regulations. (See appendix.)

A solution for these issues is already contained in the Dodd Frank Act, Section 604 and in 12 U.S.C. § 1844(c)(1)(A), effective 2011, whereby bank holding companies may be required to submit reports to the Federal Reserve to keep it informed on their financial condition, systems for monitoring and controlling financial and operating risks and compliance with federal banking laws and any other applicable provision of Federal law.

The views expressed by Ethics Metrics in this article are based on our research that applies the principles of 12 U.S.C. § 1844(c)(1)(A) to publicly available data for DIHCs with assets above $10 billion, with a focus on laws and regulations governing safety and soundness, source of strength, well managed, well capitalized, and minimum capital requirements, as well as Federal securities laws and SEC rules.


A partial summary of relevant laws and regulations follows:

  • Intentional omission of material information is a material misstatement. See PCAOB’s AU Section 316, .06. and paragraph .06 of the PCAOB’s AS 2401: Consideration of Fraud in a Financial Statement Audit.
  • Paragraph .17 of the PCAOB’s AS 2810: Evaluating Audit Results, states: Evaluation of the Effect of Uncorrected Misstatements. The auditor should evaluate whether uncorrected misstatements are material, individually or in combination with other misstatements. In making this evaluation, the auditor should evaluate the misstatements in relation to the specific accounts and disclosures involved and to the financial statements as a whole, taking into account relevant quantitative and qualitative factors. /7/ If the financial statements contain material misstatements, AS 3101, Reports on Audited Financial Statements, indicates that the auditor should issue a qualified or an adverse opinion on the financial statements. (emphasis added).
  • Management’s assessment of effective internal control over financial reporting. See 17 CFR 229.308(a)(3): “Management’s assessment of the effectiveness of the registrant’s internal control over financial reporting as of the end of the registrant’s most recent fiscal year, including a statement as to whether or not internal control over financial reporting is effective. This discussion must include disclosure of any material weakness in the registrant’s internal control over financial reporting identified by management. Management is not permitted to conclude that the registrant’s internal control over financial reporting is effective if there are one or more material weaknesses in the registrant’s internal control over financial reporting; (emphasis added).
  • Material misstatements and fraud are two of the four material weaknesses that are defined by paragraph 69 of PCAOB’s Auditing Standard No 5., June 12, 2007 to December 30, 2016: “69. Indicators of material weaknesses in internal control over financial reporting include
  • Identification of fraud, whether or not material, on the part of senior management;14/
  • Restatement of previously issued financial statements to reflect the correction of a material misstatement;15/
  • Identification by the auditor of a material misstatement of financial statements in the current period in circumstances that indicate that the misstatement would not have been detected by the company’s internal control over financial reporting; and
  • Ineffective oversight of the company’s external financial reporting and internal control over financial reporting by the company’s audit committee.”
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