By Thomas Dee, CFA

July 3, 2023 – It’s no secret financial services companies have been battered by an unusually turbulent year. The confluence of global central banks—including the US Federal Reserve, the European Central Bank, and the Bank of England—continuing to increase interest rates to tame inflation, along with several bank failures, has further fueled market uncertainty.

Less appreciated—yet still very meaningful for companies and investors alike—have been significant regulatory developments in the US that we believe the industry and markets will continue to reckon with. At the start of the year, Capstone expected 2023 to be a landmark year for US financial services regulation, as the Biden administration looks to cement scores of high-profile regulatory initiatives before the uncertainties of the 2024 election (see Biden’s Financial Services Push: 2023 Will be a Landmark Year for Regulation). From fee scrutiny to real estate commissions, bank regulation and more, we think the broader momentum will continue to play out in ways that are underappreciated. 

In a recent Q&A, Capstone’s head of Financial Services Thomas Dee provides updates to his view on what the remainder of 2023 holds for financial services policy.

What expectations did you have for the year that have already played out?

There are two main expectations that have played out. First, regulators have meaningfully ramped up their scrutiny of fintech. In April 2023, the Federal Deposit Insurance Corporation (FDIC) revealed a sweeping enforcement action against privately held Cross River Bank, a well-known financial institution serving fintechs. This came after a similar action by the Office of the Comptroller of the Currency (OCC) against Blue Ridge Bank in 2022. Still, despite the attention around these two high-profile actions, we expect regulatory scrutiny of fintechs (and their financial institution partners) to further increase. For example, we believe there is a risk that the Cross River playbook, which includes a mandate that the FDIC approve any new fintech partnerships, could be used against other financial institutions. And earlier this month, the bank regulators released new guidance on third-party risk management, highlighting the potential for greater scrutiny of fintech partners.

Second, the Consumer Financial Protection Bureau (CFPB) has continued to wage a war against what it calls “junk fees.” Most notably, in February 2023, the CFPB proposed a rule that seeks to rein in credit card late fees. The proposal would cut the safe harbor for fees to $8, from the current maximum as high as $41, a proposal that would be especially harmful for subprime and private-label card issuers, like publicly-traded Synchrony Financial (SYF) and Bread Financial Holdings (BFH). The fate of the CFPB’s proposal will depend on how the US Supreme Court rules on a pending case challenging the agency’s constitutionality. More on this later.

What do you think was overlooked in the first half of this year that clients should be paying attention to?

The real estate brokerage industry faces notable risks from a pair of lawsuits alleging inflated agent commissions. In March 2023, a judge granted class-action status in Moehrl v. National Association of Realtors, et al. Plaintiffs in one of the two approved classes are seeking $13.7 billion in damages (which may be tripled given the antitrust allegations involved), posing a risk of massive penalties for firms like Anywhere Real Estate Inc. (HOUS), Re/Max Holdings Inc. (RMAX), and Berkshire Hathaway Inc. (BRK/A).

Also in March 2023, the Canadian government announced that it was lowering the country’s criminal rate of interest from a 47% APR to a 35% APR. In the public markets, CURO Group Holdings Ltd. (CURO) and goeasy Ltd. (GSY on the Toronto exchange) are the most exposed, with an estimated 25% and 33% of revenue from loans about the new criminal rate, respectively.

What underappreciated themes do you expect to play out this year in the financial services sector?

One is rent control: A growing number of blue states are quietly pushing rent control measures, presenting likely headwinds for apartment REITs like AvalonBay Communities Inc. (AVB) and Equity Residential (EQR). Among the many states considering new measures are California and New York, where proposed bills would subject more units to rent control. 

Another key theme is mounting scrutiny of the insurance sector. The National Association of Insurance Commissioners (NAIC), which coordinates state insurance policy, is conducting an internal review of the risks presented by private equity-owned insurance companies. While the NAIC has not yet proposed policy changes, it is reviewing areas ranging from pension risk transfers and the use of offshore reinsurers to higher levels of investment in illiquid securities and investment management agreement structures.

Separately, the NAIC is contemplating risk-based capital changes for insurance companies, which would increase the capital requirements of many collateralized loan obligations (CLOs). Overall, we see emerging headwinds for PE-insurance carrier partnerships, as well as insurers that invest heavily in CLOs.

What are the big questions you are paying attention to for the balance of 2023?

The most obvious area to watch is US bank regulation. Regulators are poised to propose the adoption of the so-called Basel endgame for US banks, which we believe could increase big-bank capital requirements by as much as 200 bps. We expect a proposal, which was in development long before the recent regional bank turmoil, this summer. For regional banks, we expect a host of proposals this year, at a minimum spanning enhanced prudential standards, unrealized losses on investment securities and long-term debt. While the banking sector appears to have stabilized, we will closely monitor the health of regional banks like PacWest Bancorp (PACW) and Western Alliance Bancorporation (WAL) – and those with commercial real estate (CRE) exposure – for the balance of the year.

The future of the CFPB is also very much in question. The Supreme Court has decided to hear a challenge to the agency’s constitutionality in the October 2023 term, which suggests a decision by summer 2024. In the interim, we believe industry participants will be able to block new regulations from going into effect—and companies will have more sway in settlement negotiations with the enforcement agency.

Lastly, we will closely monitor the Securities and Exchange Commission (SEC), whose proposed equity market structure rule could create significant headwinds for broker-dealers like Robinhood Securities, Inc. (HOOD) and market makers like Virtu Financial, Inc. (VIRT). Our base case is the various rules will be finalized in early 2024. The most controversial elements will be challenged—and likely blocked—in court. For the balance of 2023, we will closely monitor developments on these SEC rulemakings, among a slew of other ambitious SEC efforts.

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