Banks don’t historically sue their regulators. Is that about to change?

What the Supreme Court, Basel III Endgame, and dirty laundry all have in common

Change is afoot

The Supreme Court, in its recent opinion Loper Bright Enterprises vs. Raimondo, suggests that the government can and should be sued by regulated entities a lot more than has been tradition. (If you are lost on the implications of this major decision, read this from my friend Chris Walker at Michigan).

My bet is that banks’ lawyers and lobbyists are cheering the demise of Chevron more than just about any legal development in my memory. So yes, I would wager that there will be a lot more litigation. And I would also wager that the Fed will sprint away from the courthouse door out of an overdeveloped fear that litigation will erode its independence.

The last wager reflects a profound error on the part of the Fed. The opposite is true, as I explained a few months ago. The Fed’s fear of conflict is itself a political act.

This post summarizes those views and explains why the Fed must not retreat from the moment. It has a lot of legal legs to stand on with respect to challenges of its traditional bank supervisory authority. Alas, the Fed’s recent behavior in the Basel III melodrama does not make me confident that it can change its direction.

First, some administrative law context

In 1984, the Supreme Court created a framework to evaluate the judiciary’s role in policing the actions taken by administrative agencies - think the EPA, the SEC, and, yes, the Federal Reserve - when those actions are challenged by plaintiffs who claim the agencies have violated the law. The Court announced two steps of interpretive inquiry. First, to determine “whether Congress has directly spoken to the precise question at issue.” If it has, then that congressional clarity decides the issue. If it hadn’t, on to step 2: if the court decides that “the statute is silent or ambiguous with respect to the specific issue” then the court will defer to the agency’s own interpretation of the statute so long as that interpretation “is based on a permissible construction of the statute.” (quotes are from Chevron vs NRDC itself.)

This deference is now dead. Judges will interpret statutes without deference to anyone. We can debate separately the rather astonishing policy authority that this now gives judges – interpreting statutes is not the same as plotting orbital paths for satellites by NASA scientists, for example – but leave that for another day. The question now: what does this mean for the Fed? 

And second, some banking law context

For over 160 years, as my co-author Sean Vanatta and I document in our forthcoming history of bank supervision (which you all should pre-order now!) the federal government has made bank risk management the mutual project of public and private power.

Long before Chevron was a twinkle in John Paul Stevens’ eye, courts nearly always stepped aside when bank supervisors muscled banks into a specific regulatory posture: the federal banking authorities’ “judgement and discretion” on these matters, the Supreme Court held in 1869, was “conclusive” and “not to be questioned in the litigation that may ensue.”

This well-entrenched judicial deference to bank regulatory decisions is more than a century older than the now-discarded Chevron doctrine. It is also at least part of the reason why we have seen, historically, very little litigation between banks and their regulators, as my colleague David Zaring has noted.

The other reason is that banks themselves have been skittish about such litigation. The common enterprise of bank risk management between banks and their supervisors means an awful lot of close collaboration behind the scenes getting the questions of risk management just right. Suing your primary risk management partner is not an obviously smart strategy, like suing your spouse without pressing for divorce. You have to eat dinner together the next day; you don’t want to make it awkward.  

So long and thanks for the shared risk management?

Today, though, banks and their lobbyists smell chum in the water. The Bank Policy Institute, for example, perhaps the most bare-knuckled representative of special interests anywhere in American politics, has already made clear that the industry’s efforts to force the Fed and other bank regulators into the center of the judicial arena are just beginning. 

The question now for the Federal Reserve and its principals: what will you do in response to these new challenges? 

The answer, based on its behavior most recently, appears to be to give hecklers a veto over regulation and to live in fear of a change to the non-litigation tradition. 

We see this most recently in the cinematically-named Basel III Endgame, a proposed and reproposed rulemaking that would have substantially expanded the amount of equity that banks, especially large ones, would have had to use to fund themselves. 

The issue of bank capital is technical but important. 

After the 2008 financial crisis, chastened banks accepted the will of Congress and regulators that they had overextended their balance sheets. 

In the aftermath of the crisis, the thinking went, new legislation and regulation would need to require banks to raise more of their funding not from flighty depositors or hot bond markets, but from stabler equity shareholders. (Read Admati & Hellwig’s revised book on the subject for the stoutest defense of this approach.)

The banks did not like this option: equity is more expensive to them, for many reasons. They would prefer the caprices of the bond markets and depositors guaranteed by the federal government to the dilution of their shareholders and the prospect that investing in banks would become, in a word, boring for those investors. 

The politics of bank capital

This isn’t just a debate about the economics of bank capital. It isn’t primarily about that. This is primarily a political contest about what values we want enshrined in our banking regulations. In the tradeoffs between bank innovation and systemic stability, do we want banks to control their own destinies with respect to funding or do we want to force them to safer waters in the name of more general stability?

To perhaps oversimplify, Republicans generally side with banks and say let them sort out their own funding. 

Democrats prefer more equity so that there are fewer opportunities in a downturn for government bailouts, since flighty debt in a pinch often leaves the taxpayers holding the bag. (There are Republicans and Democrats on the opposite sides of these debates, too, to be clear.) 

The partisan content to capital debates explains why, during the Trump Administration, the Republican-appointed regulators walked back some of these equity commitments and, after 2020, some Democrats wanted to push those commitments forward. 

Who is right about capital?

Honestly, who knows? I am profoundly skeptical of the precision at the heart of the present debates. This debate is less the quest for platonic truths discoverable by independent experts and more about weighing conceptual probabilities - fewer devastating crises (say the Democrats) versus more robust banking-fueled growth (say the Republicans). I know no better mechanism for sorting such undefined values than electoral politics, representative democracy, and accountable bureaucrats. That’s the system we have.

The banks don’t see it this way. When Fed Democratic appointee Michael Barr proposed a new rule that would expand the equity base for banks, as was widely anticipated after Biden won in 2020,  the industry saw an opening and took it. The 2020 election settled nothing, in their view. The Trump rules were the right rules, whatever the American people had to say about it. It was time to run against the proposed rule in full campaign mode. Call it the Basel election of 2023. 

During this 2023 election,  one could not read the paper, listen to a podcast, or even watch American football without being told by BPI and other bank lobbyists that this rather technical exercise of financial regulation would, in fact, destroy American prosperity. 

The industry also threatened litigation, arguing that Basel Endgame was not just bad politics but a violation of sacred constitutional rights. 

The Fed’s response

It seems to have worked. In response, the Fed might have dared the industry forward and let the necessarily political exercise of regulatory judgement be the product of its own deliberations. 

It did not. Instead, the Fed crumpled like dirty laundry tossed in a corner. In March, Fed chair Jay Powell promised “broad and material changes” to the Basel Endgame proposal. In September, citing “humility” – a word Vice Chair Barr likes to use; I propose a swear jar mandated by law or tradition into which Barr places a trillion-dollar platinum coin for every new invocation – Barr and the Fed proposed to substantially walk back the commitment to increase equity funding. 

The concern, it seemed, was that failing to do so would inject too much politics into an institution that is famously averse to such epistemic wrangling. The opposite is true. This kind of dance in the shadow of litigation and in the fear of BPI’s ad campaign threatens Fed independence. Powell, Barr, and the rest should not have indulged these antics. 

Consider the dangerous precedent Powell, Barr, and the Fed just set. With that concession in the face of overwhelming industry pressure, combined with the Supreme Court’s invitation for more litigation on regulation, the Federal Reserve put a sign outside of its headquarters on Constitution Ave: Inoffensive Regulation Only. 

The Fed’s losing gamble

Unless the Fed changes its course, how can any citizen - or bank lobbyist, perhaps more importantly - ever take it seriously again? 

All it would take for the Fed to change course on any proposed regulation is for special interests to launch a television campaign calling names or make threats of litigation. The Fed will then withdraw and try again with something much better suited to those interests. Or, more likely, it won’t ever propose rules to which those same special interests object in the first place. 

This is the wrong answer. The Fed should take the Supreme Court’s invitation to test its rules and call the industry’s bluff. 

The legal authority and historical tradition for robust bank regulation and supervision is so far away from controversy that even in a conservative court the Fed is likely to win.  

But the Fed cannot win if it will not play. The game the Fed appears to want to play on financial regulatory matters appears to be one it can never lose. 

If that’s the case, robust bank regulation and supervision in the US may well be an artifact of history. If that’s so, don’t blame the Supreme Court. Don’t even blame the banks or their lobbyists. They are merely acting in the interests of their shareholders. 

Blame the Federal Reserve. In Basel and, I fear, in the years of increased litigation risk, it has played politics in the worst way and has lost much for its efforts.   

[Note: An earlier version of this post appeared in July under paywall at Banking Risk & Regulation, a blog that is I think affiliated with the Financial Times (my confession is that I thought I was writing an op-ed for the FT). This version is significantly updated and edited.]