May 2023 financial reporting, governance, and risk management

| 5/17/2023
May 2023 financial reporting governance and risk management

Message from John Epperson, Managing Principal, Financial Services

Dear FIEB readers,

May often sees graduates embarking on new challenges and opportunities. Similarly, financial reporting, governance, and risk management evolve and introduce new challenges and opportunities for our readers. Among the emerging topics in this report are federal regulators’ supervisory reports on failed banks, a proposed special assessment, options for deposit insurance reform, and regulatory guidance on overdraft fee program risks. The Securities and Exchange Commission (SEC) adopted a final rule on share repurchases and designated a longer period for action on clawback listing standards. In addition, an SEC commissioner delivered remarks on environmental, social, and governance matters, and the chair provided testimony before the U.S. House of Representatives Committee on Financial Services.

Effective financial reporting, governance, and risk management require understanding and embracing emerging developments. We are pleased to play a role in keeping you informed as these developments occur.

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Matters of importance from the federal financial institution regulators

Fed and FDIC release reports on supervision of failed banks

On April 28, 2023, the Federal Reserve (Fed) board and the Federal Deposit Insurance Corp. (FDIC) both issued reports on the failures three days apart in March of two banks under their respective supervisions.

The Fed’s lengthy report on the failure of Silicon Valley Bank (SVB) details the Fed’s findings after a review of its own supervision of the bank leading up to the failure on March 10, 2023. Fed Vice Chair for Supervision Michael Barr led the review.

The Fed largely blamed SVB’s failure on bank mismanagement and leadership’s failure to manage basic interest-rate and liquidity risk. The report also highlights the board of directors’ failure to oversee senior leadership and hold it accountable. Lastly, the report says that Fed supervision of SVB did not work with sufficient force and urgency and that supervisors did not fully appreciate the extent of the vulnerabilities as SVB rapidly grew in asset size and complexity.

The Fed report touches on the influence of social media; the highly networked, concentrated depositor base; and the technology enabling large withdrawals over a very short period of time. The report notes that the Fed must continue to evaluate its supervisory and regulatory framework, including conducting a holistic review of the capital framework, implementing Basel III, bolstering stress-test scenarios, and improving the resiliency and resolvability of large banks through a long-term debt rule.

According to the report, the Fed will focus on improving the speed, force, and agility of supervision to ensure that supervision stays up to speed as a firm grows in size or complexity. The Fed already has begun to form a dedicated novel activity supervisory group as a complement to existing supervisory teams. The group will focus on the risks of novel activities (such as fintech or crypto activities). The Fed will identify other risk factors such as high growth or concentrations that deserve additional supervisory attention and will evaluate whether to apply standardized liquidity requirements to a broader set of firms.

The FDIC issued a report on its supervision of Signature Bank of New York (SBNY), which failed on March 12, 2023. It cited the root cause of the failure as poor management, saying the bank “pursued rapid, unrestricted growth without developing and maintaining adequate risk management practices and controls appropriate for the size, complexity, and risk profile of the institution.” According to the FDIC, SBNY “funded its rapid growth through an overreliance on uninsured deposits without implementing fundamental liquidity risk management practices and controls.” Additionally, the report notes, SBNY “failed to understand the risk of its association with and reliance on crypto industry deposits or its vulnerability to contagion from crypto industry turmoil that occurred in late 2022 and into 2023.”

Similar to the Fed, the FDIC report notes that the FDIC could have acted sooner to take supervisory actions, consistent with the forward-looking supervision concept of the Division of Risk Management Supervision. In addition, the FDIC could have produced timelier exam work products and more effective communication with SBNY’s board and management.

The FDIC report identifies matters for further study, including consideration of the need for more examiner guidance on supervising banks that are overly reliant on uninsured deposits.

FDIC proposes special deposit insurance assessment

On May 11, 2023, the FDIC board approved a proposed rule, “Special Assessments Pursuant to Systemic Risk Determination,” that would implement a special assessment to recover the cost associated with protecting uninsured depositors following the closures of SVB and SBNY. The Federal Deposit Insurance Act requires the FDIC to recover any losses to the deposit insurance fund as a result of the systemic risk determination, announced on March 12, 2023, to protect uninsured depositors of the two failed banks.

The base for the special assessment would be equal to an insured depository institution’s (IDI) estimated uninsured deposits reported as of Dec. 31, 2022, adjusted to exclude the first $5 billion in estimated uninsured deposits from the IDI. For IDIs that are part of a holding company, the $5 billion deduction would be apportioned based on its estimated uninsured deposits as a percentage of total estimated uninsured deposits held by all IDI affiliates. The FDIC is proposing to collect the special assessment at an annual rate of approximately 12.5 basis points over eight quarterly assessment periods. The FDIC would begin collecting the special assessment beginning with the first quarterly assessment period of 2024 (Jan. 1 through March 31, 2024), with an invoice payment date of June 28, 2024. The special assessment rate is subject to change depending on any adjustments to the loss estimate, mergers or failures, or amendments to reported estimates of uninsured deposits.

The FDIC estimates that 113 banks would be subject to special assessments – 48 with more than $50 billion in total assets and 65 with total assets between $5 billion and $50 billion. No banks with less than $5 billion in assets are expected to pay special assessments. The FDIC estimates banks with greater than $50 billion in assets will pay more than 95% of the special assessment.

Comments are due 60 days following publication in the Federal Register.

FDIC outlines options for deposit insurance reform

The FDIC on May 1, 2023, issued a comprehensive report on its review of the deposit insurance system, which was prompted by recent bank failures. The report evaluates three options for reforming deposit insurance: the limited coverage option that currently exists, an unlimited coverage system that would cover all deposits, and a targeted system that would allow for different levels of deposit insurance coverage across different types of accounts and provides greater coverage for business payment accounts.

The FDIC’s report presents the three options, including some advantages and disadvantages of each, along with complementary supervision tools for consideration. According to the report, the current limited coverage system does not address the risk of bank runs associated with high concentrations of uninsured deposits, even with an increase in the insurance limit. An unlimited system in which all deposits are fully insured would mostly eliminate bank runs but also would eliminate depositor discipline and might induce banks to take excessive risks.

The best option for balancing financial stability and depositor protection, according to the report, is a targeted coverage deposit insurance system in which additional coverage would be extended to business payment accounts. The FDIC suggests the targeted approach is the most promising option but acknowledges it has “significant, unresolved practical challenges” to implementation. Any modification to the deposit insurance coverage level must be approved by Congress.

The FDIC report does not address a possible special assessment fee to make up for the impact to the Deposit Insurance Fund resulting from the FDIC’s systemic risk exemption and unlimited coverage associated with the SVB and SBNY failures. An FDIC proposal on the special assessment is expected in May 2023.

OCC and FDIC issue guidance on overdraft fee program risks, CFPB citations

The Office of the Comptroller of the Currency (OCC) and FDIC on April 26, 2023, issued separate guidance addressing the risks associated with certain bank overdraft protection programs. Both agencies provide some background information on overdraft programs and address certain practices that might result in heightened risk exposure and violating Section 5 of the Federal Trade Commission Act, which prohibits unfair or deceptive acts or practices.

The OCC bulletin and FDIC financial institution letter (FIL) specifically highlight overdraft fees charged on transactions authorized against a positive balance but settled on a negative balance, often referred to as “authorize positive, settle negative” (APSN).

The OCC and FDIC also describe certain risk mitigation practices that might assist banks in managing risks associated with overdraft programs. The OCC bulletin mentions assisting customers in avoiding unduly high costs and implementing fees and practices that bear a reasonable relationship to the risks and costs of providing overdraft services. The FDIC FIL emphasizes the role third parties play in processing transactions and encourages institutions to review their third-party relationships to verify appropriate quality control over third-party arrangements and to review and understand the risks presented by third-party system settings for overdraft-related fees.

In its March 2023 “Supervisory Highlights,” the Consumer Financial Protection Bureau (CFPB) says the CFPB has cited institutions for unfairness in charging consumers APSN overdraft fees. These citations followed a circular the CFPB issued in October 2022 saying that overdraft fees assessed by financial institutions on transactions that a consumer “would not reasonably anticipate,” including APSN overdraft fees, are “likely unfair.”

FDIC issues reminder of shorter settlement cycle for broker-dealer transactions

The FDIC on April 27, 2023, issued an FIL to remind FDIC-supervised institutions of the Securities and Exchange Commission (SEC) rule implementing a shortened settlement date from two days (T+2) to one day (T+1) for most broker-dealer transactions. The SEC rule was effective May 5, 2023, with a compliance date of May 28, 2024, and the FDIC advised institutions to update their systems, operations, and processes to facilitate an orderly transition.

From the Government Accountability Office (GAO)

GAO issues preliminary review of agency actions related to March 2023 bank failures

While Fed and FDIC reports place much of the blame for March 2023 bank failures on mismanagement by the banks and the current regulatory framework, a report by the GAO on the preliminary review of agency actions related to the failures takes a more pointed stance on the supervisory failures that led to the collapse of both SVB and SBNY. The GAO report, also issued on April 28, 2023, highlights risky business strategies and weak liquidity risk management by both SVB and SBNY, with each relying largely on uninsured deposits to support rapid growth. But the GAO report focuses largely on how bank supervisors failed to escalate their concerns about the banks’ management of risk related to deposits in the months preceding the failures.

The GAO report details how regulators identified concerns with SVB and SBNY, but both banks were slow to mitigate the problems, and regulators failed to escalate supervisory actions in time to prevent the failures. Specifically, the GAO highlights slow response by the Federal Reserve Bank of San Francisco, which downgraded SVB in June 2022 and began working on an enforcement action in August 2022 but did not finalize the action before the bank failed. Similarly, the FDIC took multiple actions to address supervisory concerns related to SBNY’s liquidity and management but did not substantially downgrade the bank until the day before it failed.

From the Financial Accounting Standards Board (FASB)

FASB plans to propose acquired financial asset reporting changes

At its March 29, 2023, board meeting, the FASB completed deliberations and voted to proceed on a forthcoming proposal that would change how entities initially recognize an allowance for credit losses (ACL) on acquired financial assets subject to Topic 326, “Financial Instruments – Credit Losses.”

The board voted to propose that financial assets acquired in either a business combination or an asset acquisition would be accounted for under the purchased financial assets (PFA) model. The scope also would include acquired revolving credit arrangements with active borrowing privileges (such as credit cards and home equity lines of credit), trade receivables, and acquired financial assets not initially recorded at fair value in a business combination (for example, contract assets arising from contracts with customers).

Under the PFA model, a Day 1 allowance with the offsetting entry would be recorded as an adjustment to the initial carrying amount of the PFAs. This accounting outcome is consistent with the purchased credit deteriorated (PCD) model currently in Topic 326. Financial assets acquired in a business combination are presumed to be seasoned and therefore would apply the PFA model. For asset acquisitions, the PFA model would not apply to purchased financial assets that are in-substance originations or that are originated within 90 days of the acquisition date. For these assets, a Day 1 allowance would be recorded through a charge to earnings.

The FASB decided to propose application on a modified retrospective basis. Under that approach, the proposed guidance would be applied retrospectively to all acquisitions of financial assets occurring in or after the first reporting period in which an entity adopted Accounting Standards Update 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.”

The FASB expects to issue the proposal in the second quarter.

From the Securities and Exchange Commission (SEC)

SEC commissioner speaks on SEC and banking regulatory matters

On May 11, 2023, SEC Commissioner Mark T. Uyeda presented the keynote address at the “21st Symposium on Building the Financial System of the 21st Century: An Agenda for Europe and the United States” in Frankfurt, Germany, organized by the Program on International Financial Systems of Cambridge, Massachusetts. In his address, Uyeda focused primarily on ongoing capital markets reforms in the United States and provided some thoughts about cross-border regulation of the financial markets. His speech addressed security markets and banking sector regulatory approaches; the SEC’s current regulatory agenda, which includes many pending proposals; and the importance of robust global markets.

SEC adopts amendments on issuer share repurchase disclosures

On May 3, 2023, the SEC adopted amendments to modernize and improve disclosure requirements for repurchases of an issuer’s equity securities. The amendments will require issuers to disclose daily quantitative share repurchase information either quarterly or semiannually. If applicable, issuers will be required to check a box indicating whether certain officers and directors traded in the relevant securities in the four business days before or after the announcement of the repurchase plan or program. The amendments will require issuers to provide narrative disclosures about the issuer’s repurchase programs and practices in its periodic reports and also will require issuers to provide quarterly disclosure in Form 10-K and Form 10-Q related to the issuers’ adoption and termination of 10b5-1 trading arrangements.

The final rule is effective 60 days after the date of publication in the Federal Register. Issuers other than foreign private issuers and registered closed-end management investment companies will be required to include the quantitative data as an exhibit to their Form 10-Q and Form 10-K and provide the narrative disclosure in these forms beginning with the first filing that covers the first full fiscal quarter that begins on or after Oct. 1, 2023. For foreign private issuers and registered closed-end management investment companies the disclosures will be required in 2024.

SEC amends required private fund reporting requirements

The SEC, on May 3, 2023, adopted amendments to Form PF, the confidential reporting form for certain SEC-registered investment advisers to private funds. The amendments are designed to enhance the ability of the Financial Stability Oversight Council (FSOC) to assess systemic risk and to increase the SEC’s oversight of private fund advisers and its investor protection efforts.

The amendments will require current reporting by large hedge fund advisers regarding certain events that might indicate significant stress at a fund that could harm investors or signal risk in the broader financial system; require quarterly event reporting for all private equity fund advisers regarding certain events that could raise investor protection issues; and require additional reporting by large private equity fund advisers to improve the ability of the FSOC to monitor systemic risk and improve the ability of both the FSOC and the SEC to identify and assess changes in market trends at reporting funds.

The amendments for current reporting will become effective six months after publication in the Federal Register, and the remaining amendments will become effective one year after publication in the Federal Register.

SEC reopens comment period on beneficial ownership reporting proposal

On April 28, 2023, the SEC reopened the comment period for its proposed amendments to modernize the rules governing beneficial ownership reporting. The proposal, originally published on March 20, 2022, would accelerate the filing deadlines for Schedule 13D and Schedule 13G beneficial ownership reports; expand the application of Regulation 13D-G to certain derivative securities; clarify the circumstances under which two or more persons have formed a “group” that would be subject to beneficial ownership reporting obligations; and require that Schedule 13D and Schedule 13G be filed using a structured, machine-readable data language. In conjunction with this announcement, the SEC released a memorandum from the Division of Economic and Risk Analysis that provides supplemental data and analysis related to the proposed amendments’ economic effects.

Comments are due June 27, 2023.

SEC commissioner speaks on ESG

On April 28, 2023, SEC Commissioner Hester M. Peirce gave a speech addressing environmental, social, and governance (ESG) issues before a seminar in Stockholm presented by Eurofi, the Paris-based organizer of gatherings of financial leaders and policymakers of the European Union. Peirce shared three significant concerns related to ESG reporting:

  • ESG standards drive private capital to specific ESG-labeled assets and uses.
  • By concentrating capital in favored assets, ESG rulemaking could become a source of instability.
  • Pressure to converge on one single set of ESG standards worldwide.

Peirce expanded on her concerns that a single set of standards will direct private capital into ESG-identified activities and that could have dire consequences throughout the global economy. Peirce warned of the impossible task of having a converged set of ESG standards as this would require understanding and classifying all economic activity in terms of its effect on an increasing number of complex, sometimes mutually contradictory, metrics. She predicted that the concentration of capital in these ESG activities will create systemic instability and an investment bubble that, as history shows, will pop. Also, she said regulatory inducements to invest in particular sectors or in particular ways can harm investors, financial institutions, the financial system, and the broader economy. She noted that allowing for diversity across jurisdictions could mitigate the risks; however, that diversification would be inconsistent with pressure to converge the ESG standards. She said mutual recognition of different approaches would be a positive development, contrasted to requiring all jurisdictions to implement the same standards, which would create serious issues.

SEC designates longer period for action on clawback listing standards

On April 24, 2023, the SEC announced that it is extending the period within which to take action on the proposed rule changes from the Nasdaq Stock Market LLC and the New York Stock Exchange LLC related to establishing listing standards for recovery of erroneously awarded executive compensation. The SEC said a longer period will allow sufficient time to consider the proposed rule changes and the comments received. Accordingly, the SEC has designated June 11, 2023, as the date by which the SEC shall either approve or disapprove, or institute proceedings to determine whether to disapprove, the proposed rule changes.

SEC holds annual Small Business Forum

The 42nd Small Business Forum, hosted by the SEC’s Office of the Advocate for Small Business Capital Formation, was held April 24-27, 2023. The forum included four virtual sessions:

  • “Exploring the Early-Stage Landscape: Trends and Strategies in Capital Raising”
  • “Building Entrepreneurial Ecosystems: Laying the Groundwork to Support Small Businesses and Their Investors”
  • “Investing in Small Business: Successes and Challenges Facing Smaller Funds”
  • “Accessing the Public Markets: Becoming and Staying a Public Reporting Company”

SEC Chair Gary Gensler presented prepared remarks before the forum, Commissioner Peirce provided remarks during the “Exploring the Early-Stage Landscape: Trends and Strategies in Capital Raising” section, and Commissioner Uyeda provided remarks during the “Investing in Small Business: Successes and Challenges Facing Smaller Funds” section.

SEC chair speaks before the Financial Stability Oversight Council

SEC Chair Gensler, on April 21, 2023, made a statement before the FSOC regarding financial stability risks and guidance on nonbank determinations. He shared his support of the guidance on nonbank determinations and described it as a “step towards … helping us better protect people’s jobs, livelihoods, and trust in our financial system.”

Gensler noted that several times throughout history risks from one financial banking institution or from the banking sector have spilled into the broader economy, but he said that risks also can originate from outside the banking sector. He described the importance of recognizing that risk from both banks and nonbank financial companies can emanate throughout the economy to everyday Americans. He noted that both the SEC and the FSOC have important roles within their respective authorities to enhance the resiliency of the financial system, and although risk will never be eliminated from the system, the SEC and FSOC must strive to “identify, manage, and guard against such risk to protect the American public.”

SEC chair testifies before U.S. House committee

On April 18, 2023, SEC Chair Gensler testified before the House Financial Services Committee. Gensler said that the U.S. market faces challenges including recognizing that the U.S. cannot take its worldwide position and leadership for granted; technology, markets, and business models constantly change; and other fast-growing economies threaten to overtake the U.S. market position. He noted that the rules and regulations must be updated regularly and modernized to meet these challenges. He added that the SEC’s role in this process is directly correlated to its three-part mission to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. He said the SEC is dedicated to updating its rules to meet the challenges of the times, and he embraces comments and feedback from stakeholders in the process. In addition to discussing the efficiency and competition of the markets, Gensler highlighted all of the proposals in process and outstanding to address the ever-increasing market and rapidly changing technology.

Gensler also noted that integrity and disclosure help protect investors and build trust and increase participation in capital markets. When addressing market integrity and disclosures, Gensler focused on artificial intelligence and predictive data analytics proposals, as those areas are transforming a large part of the U.S. economy. He also discussed crypto assets and markets and climate risk disclosure.

With regard to resiliency, Gensler focused on Treasury markets, money market funds and open-end funds, and proposed improvements for systemic risk reporting on Form PF.

From the Public Company Accounting Oversight Board (PCAOB)

PCAOB enhances inspection reports

The PCAOB on May 2, 2023, announced enhancements to its inspection reports, which will be included effective immediately. The enhancements include a new section on auditor independence, more information related to fraud procedures and the identification and assessment of the risks of material misstatements, more commentary, and new graphs. These changes are designed to increase transparency and to provide more information that is relevant, reliable, and useful for investors and stakeholders.

PCAOB spotlights professional competence and skepticism

On April 25, 2023, the PCAOB issued “Spotlight: Professional Competence and Skepticism Are Essential to Quality Audits.” The PCAOB staff reminds auditors to critically assess the audit firm’s capabilities, obtain a proper understanding of the company they are auditing, and perform their work with due professional care and skepticism, in several specific phases of an audit engagement:

  • Client acceptance or continuance
  • Audit planning
  • Identifying and assessing risks of material misstatement
  • Performing the work with due professional care
  • Evaluating the results of the audit

The publication says, “the application of professional skepticism – an attitude that includes a questioning mind – is critical to planning and performing high quality audits and ensuring investors are protected. … [A]uditors should have the necessary industry expertise and knowledge of the companies they audit” in order to apply professional skepticism effectively.

PCAOB requests comments on proposed auditing standard

The PCAOB on April 17, 2023, alerted interested stakeholders of the opportunity to comment on its proposed standard, AS1000, “General Responsibilities of the Auditor in Conducting an Audit,” which was issued on March 28, 2023. The proposed standard will replace certain interim standards with a unified one that addresses the general principles and responsibilities of an auditor working under PCAOB standards.

PCAOB outlines 2023 inspection priorities

On April 17, 2023, the PCAOB issued “Spotlight: Staff Priorities for 2023 Inspections.”

The PCAOB’s 2023 inspection plan primarily reviews 2022 fiscal year-end audits. Some audits are selected randomly, while some are chosen based on risk. Inspections will focus on audit engagements with risks related to digital assets, first-year audits, multilocation audits, and significant or unusual events or transactions. Inspection priorities also include:

  • Risk of fraud
  • Auditing and accounting risks for certain financial statement focus areas
  • Risk assessment and internal controls
  • Use of the work of other auditors
  • Quality control (including independence)
  • Critical audit matters
  • Cybersecurity
  • Use of data and technology

The inspection priorities include specific considerations related to broker-dealers and financial services entities, as well as public companies engaging in M&A activities. For financial services entities, emphasis will be on audit areas that are particularly sensitive to risks related to interest rates, inflation, and uncertainty and volatility in the digital assets markets. In addition, inspectors will expand the number of audits they review for certain annually reviewed firms.

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