Regulators' safety and soundness judgments face questions

Eric Lee/Bloomberg

The concept of safety and soundness is under threat. Courts have traditionally respected regulators' determinations of whether activities are unsafe or unsound, but changes in judicial temperament portend the end to that respect. The federal banking agencies should be worried and must act accordingly.

Safety and soundness is core to the federal banking laws. The prohibition against unsafe or unsound practices was used to fine Bank of America, JPMorgan Chase and Citibank a collective $950 million in 2014 for manipulating foreign exchange rates; Wells Fargo $185 million in 2016 for engaging in systemic illegal account sales practices; and Silvergate $43 million earlier this year for failing to conduct adequate anti-money-laundering checks on its crypto customers.

Indeed, practically all enforcement actions the federal banking agencies take allege some unsafe or unsound practice. If banks are found to have engaged in unsafe or unsound practices, their regulators may impose cease-and-desist orders, collect civil money penalties, remove banks' officers and directors and the FDIC may revoke deposit insurance coverage — which effectively requires banks to cease operation.

Today, most courts hold that activities are "unsafe or unsound" if they are "contrary to accepted standards of banking operations which might result in abnormal risk or loss" or pose "a reasonably foreseeable undue risk." As these standards require simply the risk of loss and not actual losses, courts have appropriately respected examiners' judgments about whether banks' practices are so egregiously risky as to declare them unlawful.

The Supreme Court has recently shown a willingness to upend black letter law in ways that hamstring regulators, and although its opinions need not necessarily affect safety and soundness, the minimization of the concept is a likely outcome.

For example, the Supreme Court ruled in Loper Bright v. Raimondo that courts are not to defer to agencies' reasonable interpretations of ambiguous statutes; although bank regulators rarely claim Chevron deference, judges may assert that whether an action is unsafe or unsound is a question for courts alone to decide. In SEC v. Jarkesy, the Court held that agency actions similar to those at common law must be brought before juries, which may prevent bank regulators from imposing civil money penalties. And in the major questions doctrine cases, the Court held that regulators cannot address issues of "vast economic and political significance" without clear statutory authorization from Congress; although prohibitions against unsafe or unsound practices are clearly written into statute, regulators may be prohibited from using that authority to address macroprudential or not obviously financial concerns. This is all to say nothing of the case law coming out of the 5th Circuit Court of Appeals.

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September 3

John Heltman

American Banker

With this change in judicial temperament, banks' trade associations are taking the opportunity to push for fundamental changes to safety and soundness. In a recent note, the Bank Policy Institute appears to reject the notion that the concept of safety and soundness allows regulators to examine banks' information technology practices or relationships with third-party service providers, and criticizes regulators' evaluation of management as a stand-alone component in assigning supervisory ratings.

The federal banking agencies' reliance on the concept of safety and soundness is under threat, and they are likely to lose any forthcoming legal challenges without sufficient preparation. I have two recommendations.

First, because Jarkesy left open the question of whether civil money penalties are permissible in administrative adjudications (the only litigation option available to banking regulators), agencies should quickly file in federal court for a declaratory judgment determining whether that authority continues to exist. I would file such an action in the friendly D.C. Circuit. Although banks may appeal money penalty orders to conservative courts, having "good" case law already in existence could lessen conservative judges' leanings or create a circuit split necessitating the not-quite-as-conservative Supreme Court's involvement. Even if regulators do not file such an action, they should nevertheless continue seeking such penalties until the Supreme Court says otherwise.

Second, regulators should strengthen their legal theories for why certain activities should be prohibited. Declaring particular practices unsafe or unsound is not always necessary to make them illegal; failure to comply with the Bank Secrecy Act, for example, is already a legal violation. Moreover, regulators should make clear how those activities that are unsafe or unsound are "contrary to accepted standards of banking operations" and "might result in abnormal risk or loss." Because agency actions may be sustained only on the grounds articulated at the times they were taken, any regulation that relies on safety and soundness must be well justified in explaining how prohibited actions pose undue risks and could cause unwarranted losses.

Moreover, banking regulators maintain two sources of authority to declare activities unsafe or unsound: Sections 8 and 39 of the Federal Deposit Insurance Act. Section 8 prohibits all banks and bank holding companies from engaging in unsafe or unsound practices, while section 39 allows regulators to articulate safety and soundness standards that insured depository institutions must comply with. Though the regulators have previously treated these provisions as coterminous, they need not be, especially as the latter provides an explicit delegation of rulemaking authority and the former's delegation is implicit — and therefore at-risk following Loper Bright. Regulators should clarify the source of any prohibition.

The contemporary change in judicial temperament threatens the expansive concept of safety and soundness — and therefore the authority of banking regulators to ensure the stability of the financial system. But not all is lost. Agencies must develop a proactive strategy before litigation against them commences.