Crypto & Banks: Federal Regulators Shouldn’t Just Say No to a Whole Industry

Risk management is what banks do. Regulators seem to be ignoring that in their drive to severely restrain the banking industry's crypto-related activities, acting instead on the belief that 'any risk is a bad risk.' It's true crypto has endured a very rough patch and some banks have been hurt. But two experts argue that regulators should be making sure banks take appropriate risks. They suggest the present course could actually increase risk in the long term.

In the opening days of 2023, the Comptroller’s Office, the Federal Reserve and the Federal Deposit Insurance Corp. issued a terse joint statement highlighting risks to banks stemming from crypto-asset related activities.

As is de rigueur these days for regulators, the statement assures readers that banking institutions “are neither prohibited nor discouraged from providing banking services to customers of any specific class or type, as permitted by law or regulation.”

In the very next sentence, however, the regulators note that they are still assessing “whether and how” crypto activities can be conducted consistent with “safety and soundness, consumer protection, legal permissibility, and compliance with applicable laws and regulations.” More recent actions by the Federal Reserve only serve to underscore this point.

Those monitoring the evolving statements and actions on crypto might reasonably infer that regulators are compelling banks to “de-risk” by offloading all relationships with crypto-facing firms.

We’ve seen this movie before, in “Operation Chokepoint.” That was an intra-agency effort running from 2013 to 2015, coordinated by the Justice Department, with assistance from federal bank regulators.

The aim: to pressure banks to cut ties with lawful but disfavored businesses perceived to pose heightened fraud and money laundering risk. The campaign was widely criticized — and eventually denounced even by the regulators. But the net effect was to push legitimate businesses toward less-reputable and less-transparent sources of financial services.

Avoiding Regulatory Déjà Vu:

The impulse to ring-fence the banking system is understandable in the wake of the crypto failures we witnessed in 2022, but it's short-sighted.

It might feel safer to keep novel technologies that are hard to understand outside the regulatory perimeter in the short run. But it will add risk over the long haul.

Risk Management is a Longtime Purpose of Banking

Banks and other regulated financial institutions play a central role in the systems that safely hold and transfer money and assets today. The technologies used to carry out those functions differ radically from the recent past. This will continue. So it’s essential that responsible, regulated banking firms learn to adapt to new forms of risk and continue to serve the economy.

Putting aside headlines published during the “crypto winter,” it’s still too early to know whether crypto will deliver on its promises, or whether traditional card and other payment networks, or other platforms will out-innovate crypto platforms. But regulators and other federal policymakers shouldn’t prejudge the outcomes. Nor should they restrict banks to competing in only some of the arenas where crypto functions.

If Not Banks, Who?:

Banks are sophisticated players in managing risks and operating financial systems. Do we really want to drive all crypto activities away from a sector with the skills and accountability required to figure out how to do these things well?

If regulators keep banks from engaging in safe experimentation, they will stifle those contributions, increasing the chances that we end up with a fractured system, where banks cannot and do not play a role in what could prove to be a key part of the modern global financial infrastructure.

Ring-fencing banks from crypto isn’t just misguided, it’s also unnecessary. Banks are in the business of taking risk — even though that risk-taking sometimes results in serious problems. Consider both history and the present:

  • Mortgage lending and mortgage-related securities have blown up banks.
  • Mobile banking, peer-to-peer transfers and real-time settlement all carry substantial risk for fraud, scams and operational errors.
  • Currently, commercial real estate lending, a “go-to” for many institutions, has a ton of uncertainty around it, as we figure out the implications of the move from offices to work-from-home and hybrid models.
  • Consumer credit is moving up the risk curve, as credit card and buy now, pay later balances rise and inflation challenges already stretched consumers.
  • Harnessing the power of machine learning holds great promise for improving customer service and risk management — but requires a high degree of skill to get it right.

Nevertheless, regulators aren’t saying banks should be segregated from those activities. They expect them to be on top of managing the risks.

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Is Crypto the Real Threat? Or Just Old-Fashioned Concentration Risk?

We need to acknowledge that a small number of banks have in fact been adversely impacted by last year’s crypto collapses. Regulators are no doubt inclined to view those incidents as validation of their approach. Indeed, regulators have already cited recent stresses at some crypto-focused banks as evidence that such activities pose risks that may be impossible to prudently manage.

Without getting into specifics, we think these incidents have more to do with managing classic banking risks (e.g., concentration and liquidity risks) than anything specific to crypto as a technology.

Crypto Didn't Invent Risk:

Unsafe concentrations of risk have always been a problem for banking. Systemic risks must also be understood and closely monitored. These issues are challenging — and not unique to crypto.

As in all of these areas, regulators’ focus in regulating crypto and banks’ involvement with it shouldn’t be to avoid risk. It should be to make sure banks take appropriate risks.

“Appropriate risks” can cover a lot of ground. In our view, it means they shouldn’t take risks they don’t understand or can’t quantify. By definition, they can’t manage those risks.

For the rest of the risks, the focus should be on preventing risk-taking that is outsized relative to an individual institution’s strength or to the strength of the financial system as a whole.

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Regulatory Barriers to Keep Banks Out of Crypto Multiply

Today, regulators seem to be implying that when it comes to crypto-related activities, any risk is bad risk. The recent interagency guidance is just the latest in a series of actions across agencies that seems to signal that banks must stay away from crypto. These include:

  • Setting up roadblocks that prevent banks from engaging in anything that touches crypto without first obtaining regulatory approval or non-objection.
  • Issuing accounting guidance that could effectively keep banks from offering crypto custody.
  • Establishing global capital standards that would impose prohibitive capital charges on crypto-related activities and cap crypto exposures to 1% of Tier 1 capital.
  • Issuing restrictive guidelines for access to Federal Reserve Bank master accounts and services.
  • Shutting the door on proposed bank charters with crypto-related activities in their business plans.
  • Failing on their promise to deliver more nuanced guidance over the course of 2022 to establish clearer rules of the road for banks, after issuing a roadmap in late 2021.

As we head into 2023, regulators need to be more explicit about what crypto-related activities banks can engage in, and how they can manage the risks. As Federal Reserve Board Governor Michelle Bowman recognized in a speech, it won’t help banks, the banking sector or financial stability for regulators to “just say no” to all things crypto. To get this right, the industry needs an equal dose of what is worth doing and what doing it “right” looks like.

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