Together, these new laws create an uneven regulatory patchwork that has already resulted in the divestment of billions of dollars in state funds from investment managers. Investors and businesses increasingly face a choice between complying with these new state laws and achieving the ESG goals promised to investors and stakeholders. New laws introduced in 2023 expand the scope of anti-ESG laws and present significant uncertainty for an increasing range of businesses.

Fiduciary duties & non-pecuniary factors

Federal regulators and conservative lawmakers in some states are taking opposing approaches to defining the duties of fiduciaries. Investors making decisions using ESG frameworks include factors such as greenhouse gas emissions, which go beyond traditional fiduciary criteria like return on investment. The conflict reflects a philosophical disagreement between the belief that companies should work only to maximize returns, on one hand, and consideration of the interests of a wider range of stakeholders and outcomes, on the other.

In 2022, the U.S. Department of Labor (DOL) released a final rule addressing when fiduciaries may consider ESG factors in accordance with their fiduciary duties under the Employment Retirement Income Security Act of 1974 (ERISA). Under ERISA, retirement plan fiduciaries have a duty to act solely in the interest of plan participants and beneficiaries. The new rule clarifies that fiduciaries may consider ESG factors such as climate change and may select from competing investments based on collateral economic or social benefits. In late-January, 25 states filed a lawsuit in federal court seeking an injunction against the new rules.

Even before the release of the DOL final rule, several states proposed laws prohibiting the use so-called “non-pecuniary factors” in making investment decisions for state pensions and other funds. Earlier in 2022, the American Legislative Exchange Council introduced the State Government Employee Retirement Protection Act, model legislation that closely mirrors fiduciary duty bills later introduced in several states.

On March 24, Kentucky Governor Andy Beshear (D) signed House Bill 236 into law. Under the statute, “environmental, social, political, or ideological interests” not connected to investment returns may not be included in determining whether a fiduciary or proxy of the state retirement system is acting solely in the interest of the members and beneficiaries. Five non-exclusive factors, including statements of principles and participation in initiatives, are listed as evidence a fiduciary has considered or acted on a non-pecuniary interest.

In 2023, legislators introduced fiduciary duty laws of varying scope in several large states, including Ohio and Missouri. In total, legislators in more than 20 states have introduced bills amending the fiduciary duty laws covering investing and proxy voting for state retirement systems.

To further complicate matters, state pension funds in states like New York and California take the opposite approach, setting net zero carbon targets for their portfolios, for example.

ESG as boycott

Conservative politicians often claim ESG uses economic power to enact political agendas through alternative means. They argue goals like decarbonization amount to a boycott of fossil fuel companies and are a threat to the economies of states dependent on the extractive industry. New legislation expands on previous anti-boycott laws to include targeting companies that consider ESG factors.

Several states have already started the process of divesting retirement system and other funds from financial companies they claim boycott fossil fuel companies. For example, a 2021 Texas law requires the State Comptroller to publish a list of boycotting companies. The Comptroller’s initial criteria for inclusion included membership in Climate Action 100 and the Net Zero Banking Alliance/Net Zero Asset Managers Initiative, two major financial industry initiatives focused on climate change.

Utah Governor Spencer Cox (R) signed a bill into law on March 15 that goes beyond state investments to prohibit companies from coordinating or conspiring with another company to eliminate viable options for another company to obtain a product or service “with the specific intent of destroying a boycotted company.” A boycotted company is defined by the law as one that engages in aspects of the firearms industry or does not meet certain ESG standards.

Social Credit scores

Speaking in support of the Utah anti-conspiracy bill, state Rep. Mike Petersen (R) said: “I’m convinced that ESG is not a conspiracy theory, it is a conspiracy truth.” To many of its opponents and skeptics, ESG is an unaccountable shadow regulatory system that takes specific aim at industries and policies supported by conservatives.

The belief that the stated goals of ESG mask other motives is at the source of bills introduced in several states to prohibit financial institutions from using a “social credit score” to make lending or other decisions and defining the term to include ESG. The language invokes the Social Credit System in use in China, which monitors and punishes individuals and businesses for certain behaviors and serves as a type of blacklist.

Though some ESG frameworks produce numerical scores for various metrics, the comparison to the Social Credit System is rejected by ESG experts. There is no substantive overlap between China’s surveillance apparatus and ESG in goals or application.

This distinction has not dissuaded lawmakers in Florida, who enacted legislation amending state banking law to make the use of social credit scores by lenders an unsafe and unsound practice in violation of state financial institutions codes and unfair trade practices laws, subject to sanctions and penalties. The law prohibits the use of a social credit score based on factors that include, among other things, ESG standards on topics including emissions and corporate board diversity.

The Florida bill and others like it expand previous efforts by the state to divest state funds to restrict decisions on private lending, potentially involving many more financial institutions.

On the horizon

The volume of anti-ESG bills introduced in state legislatures is growing. Many are passing as the topic gains political salience, particularly on the political right. As these laws pass, they serve as models for similar legislation in other states. However, the success of future legislation faces significant headwinds.

Anti-ESG laws have been passed predominantly in states where Republicans control the governorship and both houses of the legislature. So far, there is little indication many Democrats will support these anti-ESG laws. Indeed, the growing scope of anti-ESG laws pose another roadblock to their widespread adoption. Newer laws impose restrictions on a much broader range of companies, which only increases the complexity of enforcement and increases the risk of a legal challenge.

A lack of uniformity means businesses operating in more than one state may have to make difficult choices. The broader economic consequences of anti-ESG laws are still undetermined, but compliance with these new laws presents immediate challenges.

The regulator’s monitoring of the marketplace in 2022 found 1,882 promotions from unauthorized firms that required amendment or withdrawal following intervention by the agency, an increase of 34% over the 1,410 promotions that received such treatment in 2021. An additional 8,582 promotions from authorized firms were similarly required to be amended or withdrawn, compared with just 573 in 2021, a massive increase of 1,398%.

The FCA notes that “[l]ast year we saw an increase in the use of bloggers and influencers on social media such as Instagram, Facebook, and YouTube, promoting financial products, particularly investment products, to younger age groups. We also saw an ongoing trend in the number of bloggers promoting credit on behalf of unauthorized third parties, with a particular growth in financial promotions targeting students.”

Finfluencers & regulations

The emergence of finfluencers (short for financial influencers) – individuals on social media who advocate a particular type of investment option – is highlighted in the Royal Mint’s 2022 Gen Z Investment Report, which found that 23% of young investors are followers of finfluencers.

… finfluencers need to be aware that social media is not an oasis where consumer protection law, advertising standards and intellectual property rights can be ignored.

Some see the dissemination of financial information via social media platforms as a healthy way of engaging people in investment activity, and they welcome the greater transparency inherent in this mode of communication. However, finfluencers need to be aware that social media is not an oasis where consumer protection law, advertising standards and intellectual property rights can be ignored.

Regulators around the world have begun to issue guidance to both finfluencers and their followers. The 2021 Statement on Investment Recommendations on Social Media by the European Securities and Markets Authority (ESMA), explores the boundaries between providing financial information and providing financial advice and recommendations online. Also, the Securities and Futures Commission of Hong Kong’s Guidelines on Online Distribution and Advisory Platforms stipulates that any licensed financial adviser will be held accountable through all channels, including social media. The New Zealand Financial Markets Authority has a Guide to Talking about Money Online, providing tips for consumers and finfluencers. Meanwhile, the Australian Securities and Investments Commission has an information sheet for finfluencers who include details of financial products and services in their content.

If finfluencers provide financial advice and recommendations per regulators’ definitions of those terms, they must adhere to regional regulations on authorization and conduct of business. However, the popularity of finfluencers, which is being fueled by shifting attitudes among investors and the more varied range of channels through which they can enter the investment market, makes it difficult for regulators and firms to ensure that customers are being treated fairly.

New attitudes toward investing

Factors such as new technology, the global pandemic and climate change concerns have caused shifts in investors’ attitudes. The Royal Mint report paints a mixed picture of young adults’ investment behavior. On the one hand, social media was found to have caused 17% of those surveyed to adopt a get-rich-quick mentality, with people expecting to double or triple what they had invested within a short space of time.

On the other hand, the report also finds that when losses occurred, 64% of 16- to 25-year-olds actively looked to diversify their risk by adding what they believed were “safer investments” to their portfolios. A total of 80% of that same group now dedicates a portion of their income to investing in their future, with two-fifths stating the pandemic made them realize the value of having secure finances. As a result, more than one-third have taken it upon themselves to learn about investing as a way of helping to grow their money.

A 2021 research report by the FCA highlighted that, for those investing in high-risk products, “the challenge, competition, and novelty are more important than conventional, more functional reasons for investing, like wanting to make their money work harder or save for their retirement.

Case study of a finfluencer

Paul Pierce, a former Boston Celtics pro basketball player and NBA Hall of Famer, promoted EthereumMax (EMAX), a cryptocurrency coin or token, on social media as did many other celebrities. In his tweets, Pierce showed screenshots of alleged profits along with links where followers could make purchases. Pierce is one of many celebrities who made such claims of financial gain using these types of investments. During his promotion of EMAX tokens on Twitter, Pierce failed to disclose that he was paid for his promotion with EMAX tokens worth more than $244,000, the US Securities and Exchange Commission (SEC) alleged.

“This year, we will continue to put the pressure on people using social media to illegally promote investments, which put people’s hard-earned money at risk.”

— Sarah Pritchard  | Executive Director for Markets, Financial Conduct Authority

Pierce has now agreed to pay more than $1.4 million to settle charges he illegally promoted digital assets, the SEC stated in February. This settlement is larger than the $1.26 million paid by Kim Kardashian to settle similar SEC charges related to promoting EMAX. The settlements with Pierce and others mark the latest move by the SEC to crack down on celebrity endorsements of crypto products.

The increase in the number of noncompliant finfluencer promotions suggests that as investors appear more willing to take risks, firms’ marketing departments may be tempted to make financial promotions more exciting.

In the UK, for example, regulations are based on the principle of being clear, fair and not misleading. Regulations also provide detailed requirements for firms about including the need for financial promotions to give a fair and prominent indication of any relevant risks, and to be presented in a way that is likely to be understood by the average member of the group to whom it is directed. Further, these promotions cannot disguise, diminish or obscure important elements, statements or warnings.

The future

This year, there won’t likely be any letup in regulators’ focus on the use of financial promotions. Sarah Pritchard, executive director for markets at the FCA, gave clear indication what the future holds. “This year, we will continue to put the pressure on people using social media to illegally promote investments, which put people’s hard-earned money at risk,” she said.

As the number of tools and resources issued by regulators for monitoring promotions increases, so too does the risk to firms of being caught for noncompliant behavior. The FCA is consulting on the introduction of tougher checks for financial promotions and measures that will remove harmful promotions more quickly.

Finally, firms in the UK need to consider the impact of the new Consumer Duty, which many are due to implement in July 2023. “Under the duty, firms will need to demonstrate that they are providing consumers with information which helps them to make effective and informed decisions about financial products and services,” the FCA stated.

In the US, the SEC is moving to chastise all bad actors, not just celebrities, according to Gurbir S. Grewal, director of the SEC’s Division of Enforcement. “The federal securities laws are clear that any celebrity or other individual who promotes a crypto-asset security must disclose the nature, source and amount of compensation they received in exchange for the promotion,” Grewal said.

As workloads are increasing, there is also a limit on the finite resources available to manage these growing compliance burdens. These concerns are compounded by a diverse and expanding range of subject areas with which compliance officers need to be familiar as well as an expectation of a greater volume of regulatory change. This larger picture is set against increased costs and difficulties in recruiting skilled compliance staff.

Overall, survey respondents outlined a sector that held greater responsibility but also contained practical operational challenges that threaten to undermine efforts to provide their firms with the level of compliance support required in today’s environment.

Thomson Reuters Regulatory Intelligence’s 14th annual survey of compliance leaders — distilled into the 2023 Cost of Compliance Report — was undertaken against this backdrop. The report explores the challenges that compliance officers face in 2023 and exposes the depth of issues that compliance leaders have encountered. The survey was taken of more than 350 practitioners, representing global systemically important banks (G-SIBs), other banks, insurers, asset and wealth managers, regulators, broker-dealers, and payment services providers mainly in the United States, the European Union, and the United Kingdom.

Overall, survey respondents outlined a sector that held greater responsibility but also contained practical operational challenges that threaten to undermine efforts to provide their firms with the level of compliance support required in today’s environment.

Some of the key findings of the annual report include:

• • • The volume of regulatory change was expected to increase and was seen as a key compliance challenge for boards and compliance officers.
    • Cost pressure and balancing competitive and compliance pressures were reported as key challenges, yet 45% of respondents did not monitor their cost of compliance with regulations across their organizations.
    • One-third of respondents expected compliance teams to grow, and the cost of compliance staff was also expected to increase, while turnover of staff and budgets remain at 2022 levels. An increase in the number of firms using outsourced providers for their compliance functionality was also reported.
    • Retaining skilled resources is seen as essential to deliver on a growing range of subjects with which the compliance function is involved. The recruitment of the appropriate talent comes at a cost, and the appeal of becoming a compliance officer has been reduced due to the potential for increased personal liability.
    • Low staff morale is emerging as a key conduct risk for many financial services firms. This may lead to wider noncompliance issues due to staff error or manipulation. Couple this with the identification of cybersecurity as a prominent culture and conduct risk, and it becomes more important for firms to ensure internal security controls are robust.
    • Firms operated an effective compliance culture despite the conduct and culture risks, with respondents predicting they will spend more time on culture and conduct issues in 2023.

The findings of this annual report are intended to help financial services firms with planning and resourcing while allowing them to benchmark their own approaches with those of the wider industry. The experiences of the G-SIBs are analyzed where these can provide a sense of the stance taken by the world’s largest financial services firms.

You can download a full copy of Thomson Reuters Regulatory Intelligence’s 2023 Cost of Compliance Report, here.

The remarks, made recently at the Association of Certified Anti-Money Laundering Specialists (ACAMS) conference, are far from surprising, given the flood of targeted sanctions imposed by governments worldwide since Russia’s February 2022 invasion. And the fact that Russian oligarchs have sought to shield their assets and evade sanctions by assigning family members, associates, and others as nominee owners only has added to the work banks must do.

During early examinations, regulators found that banks were struggling to comply with “regional-focused sanctions” imposed by the United States Treasury’s Office of Foreign Assets Control (OFAC), said Lisa Arquette, associate director, anti-money laundering (AML) and cyber fraud branch with the Federal Deposit Insurance Corporation, and speaker at the ACAMS conference. “Those became a little bit more difficult for institutions to implement at the beginning,” Arquette noted. “But I think they’ve worked through that, and OFAC as a partner to financial institutions has done a lot of outreach.”

Arquette explained that it was vital that when there is a change in beneficial ownership of a legal entity customer, banks should “make sure you have a process to identify that person or those people so that they can also be scanned” against sanctions lists. “There are lots of moving parts related to a lot of commercial entities and legal entities — intentionally — and it’s difficult to know who to add to the scanning process to make sure that you’re not processing transactions that should be blocked or rejected.” she said.

“Malicious actors, threat actors, intentionally may change that information, which is why your diligence is so critically important.”

Stretching ‘finite resources’

As the deluge of Russia sanctions came in wave after wave, banks with “finite resources” needed to devote “an incredible amount of time and energy [to] sanctions compliance,” said speaker Koko Ives, manager, Bank Secrecy Act AML compliance section in the Division of Supervision and Regulation at the Federal Reserve Board. “The pace, the number, the complexity, of Russia sanctions was really unprecedented,” Ives said.

“The global response with E.U., U.S. and U.K. coordination but not identical sanctions, made it particularly difficult for globally operated institutions to navigate all those sanctions, and that was done well,” Ives said. “I guess their existing sanctions programs were pretty strong because that was surprisingly well done in an incredibly time-intensive and difficult [environment].”

The Fed is examining “with the same frequency as before” and “nothing has changed with our examination process,” she added. “Any sort of [bank compliance] issues are garden variety… related to not being able to update software for [sanctions lists] timely enough so there might be something that slips through, or misunderstanding of [OFAC] general licenses, that kind of thing that causes compliance issues.”

Most banks have done ‘really good job’

Another speaker, Donna Murphy, deputy comptroller for compliance risk with the Office of the Comptroller of the Currency (OCC), said she “would echo” what Arquette and Ives said and added that “institutions spent a tremendous amount of resources dealing with those very fast-moving and complex sanctions programs, and in general did a really good job.

“Where we’ve seen issues is where the sanctions programs were not dynamic enough and sometimes maybe didn’t have the capability — at least initially, and it had to be built — to deal with targeted, regional sanctions as opposed to country sanctions, or the complex and evolving structures of some of the sanctioned entities,” Murphy said.

Changes in beneficial ownership or control of legal entities “are very difficult to keep up with as sanctions are evolving and the entities are evolving,” she explained. “It is challenging and needs a lot of focus. I think in general the institutions have done a very good job of implementing these really critical programs for our national security.”

Murphy said the OCC has “spent a lot of time focusing on providing as many resources as possible to our examiners.”

She noted that sanctions have not always been a major focus of OCC supervision, but “we’ve really tried to make sure that our examiners understand these evolving and changing sanctions, and [that] we can provide the support for the exams and the institutions.”

Ives added that some Fed supervised institutions have taken “a forward-looking view of the next geopolitical target.

“Some of the institutions are already developing potential strategies if there are going to be new sanctions in a new part of the world, how might that affect the supply chain, assets that could get hung-up, parties you can no longer transact with, and how that may impact their operations,” Ives noted.

Using interagency regulatory guidance

On the topic of third-party risk management, both Arquette and Ives noted that updated interagency regulatory guidance is imminent and could be released any day. Use of third parties by financial institutions is increasing, Ives added. “It can be incredibly beneficial, especially in the fintech area where [banks] may need the expertise,” she said. “But how is [suspicious activity report] information going to be shared? Do you have what you need to be on the right side of sanctions compliance?”

The intent of the updated interagency guidance is to make consistent federal banking agency guidance on third-party risk management “to make it manageable and holistic” for financial institutions, Ives said.

For several years, the SEC has monitored firms’ practices in offering services based on clients’ preferences on ESG and other investing factors related to corporate responsibility along with other factors that go beyond immediate bottom-line concerns.

In the past, the agency has cited the broad provisions of Section 206 of the Advisers Act, which requires disclosure of material facts to bring ESG-related actions. But since last November, the SEC has gained broader authority under the newly implemented Marketing Rule to examine all of firms’ compliance processes for advertising and marketing material, including ESG claims. “We’re testing under the Marketing Rule previously known as the Advertising Rule where you know the basic principle is to not make any misleading advertisement (related to ESG),” said Ashish Ward, the SEC Los Angeles branch chief.

Rulemaking by examination?

Some critics have argued that examiners are pushing ahead with their reviews of ESG at a time when the agency’s own rulemaking process has been facing challenges in defining the basic terms of what constitutes ESG.

However, the SEC sees it differently. Its SEC examinations unit says it has avoided substantive concerns of investment advisers’ ESG decisions, focusing instead on disclosure and documentation. The SEC exam unit also argues that it is implementing risk-based principles based on existing securities law, and it has taken the view that financial services firms must document and disclose the factors that they are using in advising clients.

“While the concern over whether the commission is using its examination or enforcement powers to advance its ESG-related rule making agenda is a fair question to raise,” said Ken Joseph, managing director for financial services compliance and regulation at Kroll. “The commission has already demonstrated in recent enforcement cases that the federal securities laws — including the anti-fraud provisions of the Advisers Act — provide a legal framework for charging alleged false or misleading ESG-related claims or inadequate compliance policies and procedures.”

“Examiners are tasked with evaluating claims made to clients or actual or prospective investors — neither the Marketing Rule nor the proposed ESG-related rule changed that dynamic,” Joseph adds.

Firms face widening ESG compliance risk

With the expansion of rules and priorities by the SEC, what is clear is that the risk of action by the agency because of compliance issues has expanded. Investment advisers will face compliance concerns they have never faced in the past under the new Marketing Rule because the rule adds even more emphasis on raising the bar for compliance units to have processes in place to assure ESG claims are accurate. In addition, the SEC has also created a 22-member Climate and ESG Task Force in its Division of Enforcement to better monitor firms’ and issuers’ ESG practices.

Navigating the complexity in compliance risk for issuers will be tricky in the near term, but adding ESG evaluations in disclosures only adds to the murkiness. “Due diligence can be become difficult with respect to evaluating ESG factors at issuers given the varying types of disclosures that they provide,” explains SEC branch chief Ward, adding that those

Bill Singer of the Brokeandbroker blog, a securities lawyer and former counsel for the Financial Industry Regulatory Authority (FINRA), says some brokerage firms are worried about how the SEC exam unit is viewing ESG. “There are a lot of concerns at firms that the SEC exams can look all over the firm for ESG issues that could pose compliance problems,” says Singer. “I’m hearing from firms that this ESG focus in examinations — and now with a special ESG task force — they will be getting hit with more deficiency letters and enforcement actions. They see it as rulemaking by examination.”

The SEC’s proposed ESG rules in total should give firms a reason to work on their compliance practices in advance of new rules, states law firm Mayer Brown LLP in a recent client note. “Although not directly embedded in any new rule or amendment, an SEC expectation is clearly set out in the proposal: that funds and advisers would adopt new compliance policies and procedures regarding their ESG-related strategies in order to help ensure the accuracy of the various prospectus and brochure disclosures,” the client note states.

“You should look at everything you say [on ESG] and ask if you can substantiate that it’s true,” the SEC’s Ward adds. “That’s going to flow through everything, and that’s going to help fix a lot of problems.”

In what Fed Vice Chair for Supervision Michael Barr called an “unflinching” review of the U.S. central bank’s supervision of SVB, the Fed said its oversight of the Santa Clara, California-based bank was inadequate and that regulatory standards were too low. “SVB’s failure demonstrates that there are weaknesses in regulation and supervision that must be addressed,” Barr said in a letter accompanying a 114-page report, which also was supplemented by confidential materials that are typically not made public.

While it was the regional bank’s own mismanagement of basic risks that was at the root of SVB’s downfall, the Fed said, supervisors of SVB did not fully appreciate the problems, delaying their responses to gather more evidence even as weaknesses mounted, and failed to appropriately address certain deficiencies when they were identified. At the time of its failure, SVB had 31 unaddressed citations on its safety and soundness, triple the number its peers in the banking sector had, the report said.

One particularly effective change the Fed could make on supervision would be to put risk mitigation methods in place quickly in response to serious capital, liquidity, or management issues, a senior Fed official said, adding that such increased capital and liquidity requirements also would have bolstered SVB’s resilience.

Barr said that as a consequence of the failure, the central bank will reexamine how it supervises and regulates liquidity risk, beginning with the risks of uninsured deposits.

Regulators shut SVB on March 10 after customers withdrew $42 billion on the previous day and queued requests for another $100 billion the following morning. The historic run triggered massive deposit outflows at other regional banks that were seen to have similar weaknesses, including a large proportion of uninsured deposits and big holdings of long-term securities that had lost market value as the Fed raised short-term interest rates.

New York-based Signature Bank failed two days later (the Federal Deposit Insurance Corporation release its review of that collapse the same day as the Federal Reserve’s assessment of SVB), and the Fed and other U.S. government authorities moved to head off an emerging crisis of confidence in the banking sector with an emergency funding program for otherwise healthy banks under sudden pressure and guarantees on all deposits at the two banks.

Supervision headcount fell

Before the twin bank failures in March, banking regulators had focused most of their supervisory firepower on the very biggest U.S. banks that were seen as critical to financial stability. The realization that smaller banks are capable not only of causing disruptions in the broader financial system but of doing it at such speed has forced a banking regulators to rethink their position.

“Contagion from the failure of SVB threatened the ability of a broader range of banks to provide financial services and access to credit for individuals, families, and businesses,” Barr said. “Weaknesses in supervision and regulation must be fixed.”

In its report, the Fed said that between 2018 to 2021 its supervisory practices shifted, and there were increased expectations for supervisors to accumulate more evidence before considering taking action. The staff interviewed as part of the Fed’s review reported pressure during this period to reduce burdens on firms and demonstrate due process, the report said.

Barr signaled in his accompanying letter that this situation would change. “We need to develop a culture that empowers supervisors to act in the face of uncertainty,” he said.

Between 2016 and 2022, as assets in the banking sector grew 37%, the Fed’s supervision headcount declined by 3%, according to the report. As SVB itself grew, the Fed did not step up its supervisory game quickly enough, the report showed, allowing weaknesses to fester as executives left them unaddressed, even after staff finally did downgrade the bank’s confidential rating to “not-well-managed.”

The Fed is looking at linking executive compensation to fixing problems at banks designated as having deficient management so as to focus executives’ attention on those problems, a senior Fed official said in a briefing.

One thing the report did not do was place any blame at the feet of San Francisco Fed President Mary Daly, with a senior Fed official telling reporters that regional Fed bank presidents do not engage in nor have responsibility for day-to-day supervision of banks in their regions.

While the fallout from the failures of SVB and Signature themselves may have subsided, the ripple effects continue. The forced sale on May 1 of San Francisco-based First Republic Bank after its deposit outflows following the SVB and Signature collapses exceeded $100 billion shows that smaller, regional banks may not be out of the proverbial woods yet.

This blog post was written by Chris Prentice & Hannah Lang, both of Reuters News; with additional reporting by Ann Saphir.

It remains to be seen whether the Treasury’s document will have any impact on de-risking, but experts expressed well-founded skepticism following its release last week.

De-risking has been a major issue in the United States since shortly after the 9/11 terrorist attacks and the enactment of the USA PATRIOT Act of 2001. At the time, embassies, money services businesses, and charities were the first sectors to be seen as too risky, or as posing too high a compliance cost, to banks. In recent years, however, de-risking has grown in the correspondent banking space and has left people in some regions and even nation-states unable to receive funds transfers — such as desperately needed remittances from family members — from the United States.

Treasury’s 54-page De-risking Strategy, which was mandated by Congress in the Anti-Money Laundering Act of 2020, probes the phenomenon of de-risking and outlines its causes, victims, and recommended policy options to combat it. Treasury said the administration of President Joe Biden “places a high priority on addressing de-risking, as it does not only hurt certain communities but can pose a national security risk by driving financial activity outside of regulated channels.”

De-risking has been a major issue in the United States since shortly after the 9/11 terrorist attacks and the enactment of the USA PATRIOT Act of 2001.

Wally Adeyemo, Deputy Treasury Secretary, stated that “broad access to well-regulated financial services is in the interest of the United States. [And] this strategy represents the next step in Treasury’s longstanding commitment to combatting de-risking and highlights the importance of financial institutions assessing and managing risk.”

Treasury said it engaged in “extensive consultation” with the public and private sectors — including banks, money service businesses (MSBs) of various sizes, diaspora communities that depend on these businesses for remittances, and other small businesses and humanitarian organizations to better understand the impacts of de-risking. Unsurprisingly, Treasury found that “profitability is the primary factor in financial institutions’ de-risking decisions” and that the costs of conducting adequate due diligence and doing other anti-money laundering or counter-terrorist financing (AML/CFT) work is a key element of the decision-making process.

Other factors fueling de-risking “include reputational risk, risk appetite, a lack of clarity regarding regulatory expectations, and regulatory burdens, including compliance with sanctions regimes,” the strategy paper states, also noting that banks interviewed by Treasury said: “They tend to avoid certain customers if they determine that a given jurisdiction or class of customer could expose them to heightened regulatory or law enforcement action absent effective risk management.”

The strategy document also states that the customers facing de-risking challenges “most acutely” include: MSBs that offer money-transmitting services, non-profit organizations (NPOs) operating in high-risk jurisdictions, and foreign financial institutions with low correspondent-banking transaction volumes, particularly those operating in financial environments characterized by high AML/CFT risks.

Strategy recommendations

The Treasury’s strategy document makes several counter-de-risking recommendations for the federal government, including:

• • • Promoting consistent supervisory expectations, including through training to federal examiners, that consider the effects of de-risking.
    • Analyzing account termination notices and notice periods that banks give to NPO and MSB customers and identify ways to support longer notice periods when possible.
    • Considering regulations that require financial institutions to have reasonably designed and risk-based AML/CFT programs supervised on a risk basis, possibly taking into consideration the effects on financial inclusion.
    • Considering clarifying and revising AML/CFT regulations and guidance for MSBs in the Bank Secrecy Act(BSA).
    • Bolstering international engagement to strengthen the AML/CFT regimes of foreign jurisdictions.
    • Expanding cross-border cooperation and considering creative solutions involving international counterparts, such as regional consolidation projects.
    • Supporting efforts by international financial institutions to address de-risking through related initiatives and technical assistance.
    • Continuing to assess the opportunities, risks, and challenges of innovative and emerging technologies for AML/CFT compliance solutions.
    • Building on Treasury’s work to modernize the U.S. sanctions regime and its recognition of the need to calibrate sanctions precisely, in order to mitigate unintended economic, political, and humanitarian consequences.
    • Reducing burdensome requirements for processing humanitarian assistance transactions.
    • Tracking and measuring aggregate changes in banks’ relationships with respondent banks, MSBs, and non-profit organizations.
    • Encouraging continuous public and private sector engagement with MSBs, non-profit organizations, banks, and regulators.

No short-term fix

Of course, Treasury’s strategy will not significantly impact the de-risking challenge in the short term. In the past, Treasury has hosted public-private sector dialogues and has encouraged financial institutions to rethink their de-risking practices, but nothing notable has been achieved.

Further, the U.S. government has no authority to force financial institutions to serve particular customers or even customer types, so the most viable government solutions to de-risking lie in making financial institutions comfortable accepting customers that may pose high financial-crime risks, while lowering the compliance costs associated with banking such customers.

Some of the recommendations above, particularly the promotion of consistent supervisory expectations, could potentially have a modest impact, but not in the short term, according to veteran AML compliance officers at two U.S. financial institutions.

The South Florida-based Financial & International Business Association (FIBA), a trade group, has long called on the U.S. government to address de-risking. “To me, the importance is that Treasury has issued a comprehensive document outlining the true reasons why de-risking occurred and [why it] continues to impact key areas such as correspondent banking,” explained David Schwartz, FIBA’s president and chief executive. “The strategies, however, are not new and do not provide a solution to this complex problem.”

Treasury plans to continue its dialogue with the private sector. “In the coming weeks and months, Treasury will be reaching out to partners in the public and private sector to coordinate the best path forward to implement the recommendations in the strategy,” the agency stated.

What is new?

The CSRD builds upon previous regulations such as the E.U.’s Non-financial Reporting Directive (NFRD) and increases the depth and breadth of organizations that are impacted. Some of what is in the CSRD includes:

• • • New regulations mandate reporting from companies of all sizes — According to the official CSRD guidelines, approximately 50,000 large, medium, and small-sized companies in the E.U. will need to apply the CSRD rules starting between 2024 and 2029. Indeed, large companies or large groups with consolidate subsidiaries must meet two of these three criteria — €40 million in net turnover, €20 million in assets, or 250 or more employees. International companies with subsidiaries located in the E.U. will need to abide by the CSRD if they conduct significant operations there.
    • Impact on society and climate is part of CSRD — A double materiality approach, which requires businesses to disclose climate change related risks as well as the impacts that such risks have on society and climate, will be required by the CSRD, which signals a new approach to unaccustomed U.S. and international companies.
    • The supply chain information mandate is here — The CSRD requires Scope 3 reporting, which includes the collection of sustainability information across a company’s value chain or supply chain. Many U.S. companies have only been reporting their Scope 1 and 2 emissions, if any. Target dates for reporting requirements vary, and reporting exemptions exist as well.
    • Third-party verification for assurance is required — Verification by an independent assurance service provider (g., a third-party audit) will assess the processes that a company has in place for gathering data. This, along with the need to digitalize data, will ultimately require companies to invest in technology to ensure reliable data-gathering processes and a reliable data trail. This is consistent for both the E.U. and non-E.U. parent scoping. At first, limited assurance is sufficient, but the European Commission intends to move to reasonable assurance in the future.

Digitization requirements & costs

Reporting in compliance with the CSRD will incorporate the increasing demand for digitization. Companies will be required to prepare their reporting in XHTML format in accordance with the European Single Electronic Format Regulation. Companies are also required to tag sustainability information within the report according to a digital categorization system, which should be developed with the European Sustainability Reporting Standards (ESRS).

Digitalization in sustainability reporting makes information transfer more efficient and easier to locate. It also promotes transparency and accountability and carries potential significant cost savings for companies. Digitization also allows greater accessibility of data for investors and key stakeholders.

The immediate downside to digitization is the cost factor. While the CSRD requirements will likely lead to higher costs in the short term, the E.C. notes that companies will likely face an increase in costs anyway due to the growing demand for sustainability information. At the same time, the short-term costs are likely to be negated with the goal to incorporate and harmonize reporting requirements in the medium- to long-term timeframe.

Another challenge that remains is the multiple overlapping frameworks and standards already in place, although efforts to align them are evolving. The ESRS need to be consistent with the ambition of the European Green Deal as well as with the E.U.’s current legal frameworks, the Sustainable Finance Disclosure Regulation (SFDR) and the E.U. Taxonomy.

Through the European Financial Reporting Advisory Group, the CSRD has incorporated key elements of the ESRS, which draws upon several existing frameworks including the Global Reporting Initiative (GRI) and the International Sustainability Standards Board-driven (ISSB) Taskforce for Climate related Financial Disclosures (TCFD) framework. In fact, the E.C. supports TCFD to develop the global baseline, and collaboration between GRI and ISSB continues to evolve.

Recommended actions to take now

With the E.U. and CSRD leading the way with the most stringent reporting regulations thus far, international companies need to prepare themselves for the future of reporting in their jurisdictions. For industry professionals facing the challenge of the sustainability regulatory environment, the following actions are recommended:

• • • Get familiar with CSRD regulations — Expanding the rigor of ESG reporting with the CSRD is a key first step. Studying the CSRD and implementing similar reporting standards, such as Scope 3 and double materiality, can give companies a head-start in their reporting journey. In fact, stakeholders and investors are likely to look favorably on the increased transparency and preparedness of the company for upcoming regulation, such as the Security Exchange Commission’s rules on Scope 3.
    • Benchmark with peers — Understanding how peer companies are engaging with Scope 3 emissions and how they approach sustainability reporting are a necessary action to stay up to date on where your organization stands against competitors. U.S. companies unaffected can use the CSRD regulation to analyze how their E.U. competitors are reporting to give them valuable insight for when the requirements from the SEC are updated.

Over the next five years, new regulations around ESG will continue to increase, while deadlines come due for implementation of existing regulations. At the same time, companies in the short term will experience headaches around increased costs and complexity around global frameworks and standards.

What is clear, however, is that ESG reporting requirements are more stringent than ever, and companies need to prepare themselves to meet these new requirements.

There seems little question that AI will lead to an upheaval among U.S. investment banks and brokerage firms. In a recent report, Goldman Sachs estimated that 35% of employment in business and financial operations is exposed to so-called generative artificial intelligence, which can generate novel, human-like output rather than merely describing or interpreting existing information. Indeed, ChatGPT is a generative AI product from research laboratory OpenAI.

While the Goldman Sachs analysis did not drill down to AI’s specific impact on investment research, Joseph Briggs, one of the report’s authors, said that “equity research is a bit more highly exposed, at least on an employment-weighted basis.”

ChatGPT & Fedspeak

There are many questions over how far AI applications can go in replacing human input and analysis, but new academic research suggests that ChatGPT can perform certain Wall Street tasks just as well as experienced analysts — even those tasks that may appear more nuanced in nature.

A new study from the Federal Reserve Bank of Richmond used Generative Pre-training Transformer (GPT) models to analyze the technical language used by the Federal Reserve to communicate its monetary policy decisions. Experts on Wall Street whose job it is to predict future monetary policy decisions — also known as Fed watchers — apply a blend of technical and interpretive skills in reading through the often opaque and obscure language that Fed officials use in their communications with the public.

There are many questions over how far AI applications can go in replacing human input and analysis, but new academic research suggests that ChatGPT can perform certain Wall Street tasks just as well as experienced analysts.

GPT models “demonstrate a strong performance in classifying Fedspeak sentences, especially when fine-tuned,” the analysis said, cautioning, however, that “despite its impressive performance, GPT-3 is not infallible. It may still misclassify sentences or fail to capture nuances that a human evaluator with domain expertise might capture.”

Fed watchers are also known to make errors in judging future monetary policy decisions, which raises questions about how ChatGPT and similar technology could be applied to less-nuanced Wall Street tasks, such as company earnings projections or more fundamental industry research.

Laws regarding AI usage lag innovation

Just how should investment banks and other investment firms approach the use of ChatGPT in their research efforts and communications with clients? The short answer from legal experts is, cautiously.

“The state of AI regulation in the U.S. is still in its early stages,” said Mary Jane Wilson-Bilik, a partner at the law firm Eversheds Sutherland in Washington, D.C. “Many regulatory agencies have issued guidelines, principles, statements, and recommendations on AI… but laws specific to AI and ChatGPT are relatively few.”

That is not to say regulations will not be forthcoming. In late April, four U.S. federal agencies issued a joint statement warning of the “escalating threat” from fast-growth artificial intelligence applications, citing a range of potential abuses. The agencies called on firms to actively oversee the use of AI technology, including ChatGPT and other “rapidly evolving automated systems.”

 Four U.S. federal agencies issued a joint statement warning of the “escalating threat” from fast-growth artificial intelligence applications, citing a range of potential abuses.

The Securities and Exchange Commission has indicated it plans to issue a rule proposal on decentralized finance tools this year, but it is unclear whether the proposal will require specific disclosures on whether AI/ChatGPT was used when providing advice or reports to customers.

Given the regulatory vacuum on specific rules for Wall Street research, Wilson-Bilik cautioned firms on how they use and disclose AI and ChatGPT in their research products. “While there are no legal requirements just yet to tell clients that AI was used in the writing of a report or analysis, it would be best practice,” she said. “Some firms, out of an abundance of caution, are adding language about the possible use of AI into their online privacy policies.”

While clients do not currently have a legal “right to know” whether AI was used in generating a research report, “risks would arise if the client was misled or deceived on how AI was used,” Wilson-Bilik explained. “If firms use AI in a misleading or deceptive way — for example, by implying or stating that results are human-generated when the results are a hybrid or mostly AI-generated — that would be a problem under the anti-fraud statutes.”

Legal experts also warn that AI tools should be checked for accuracy and for bias. Without robust guardrails, there could well be cause for regulatory action or litigation.

Stress in the commercial real estate sector could be the next big concern for U.S. regional banks and regulators, as losses emanating from higher interest rates manifest over the coming months, analysts and bankers say. A portion of this fear stems from the possibility that each regional bank could be the next to suffer a major loss.

As banks report their first-quarter earnings, investors are scrutinizing the results for signs of stress or weakness following SVB’s collapse last month. So far, the earnings picture has not revealed any hidden bombshells, but experts say the pressures on banks’ financial health are likely to become more pronounced in the months ahead.

Of greatest concern is the banking sector’s exposure to commercial real estate (CRE), particularly the office sector. “Compared to big banks, small banks hold 4.4-times more exposure to U.S. [CRE] loans than their larger peers,” stated a new analysts report from JPMorgan Private Bank. “Within that cohort of small banks, CRE loans make up 28.7% of assets, compared with only 6.5% at big banks,” the report continued. “More worrying, a significant percentage of those loans will require refinancing in the coming years, exacerbating difficulties for borrowers in a rising rate environment.”

A separate Citigroup analysis found that banks represent 54% of the overall $5.7 trillion commercial real estate market, with small lenders holding 70% of CRE loans. More than $1.4 trillion in U.S. CRE loans will mature by 2027, with approximately $270 billion coming due this year, according to real estate data provider Trepp.

High vacancy rates

The office sector faces significant challenges following the COVID-19 pandemic, which forced a potentially permanent shift to remote work for millions of employees. A seismic shift in employee mentality following a period of flexible, remote working has led to a continued acceptance of remote and hybrid opportunities. With this change, office vacancy rates remain high across many U.S. cities. The current overall vacancy rate of 12.5% is comparable to where it was in 2010, one year after the onset of the Global Financial Crisis.

Further, chief executives from some of the largest banks have pointed to risks in the commercial real estate sector. “Weakness continues to develop in commercial real estate office,” said Wells Fargo Chief Executive Charlie Scharf on a recent earnings call with analysts. The bank set aside an additional $643 million in the first quarter for credit losses, mainly driven by expectations of higher CRE loan defaults.

California market in focus

With the tech and venture capital sector having borne the brunt of SVB’s collapse, recent data shows that California’s CRE market is one of the hardest hit in the country. San Francisco and Los Angeles had an average office vacancy rate of 21.6% in the first quarter, according to data from commercial real estate firm Cushman & Wakefield. And loans for San Francisco offices now face the highest risk of default of all U.S. metro areas.

“Difficulties are emerging by geography,” noted the JPMorgan report, adding that “Chicago and San Francisco are much more challenged than Miami, Raleigh, and Columbus, for example.”

CRE weakness is likely to affect banks of all sizes, but small and regional banks have, on a percentage basis, the greatest exposure. “While total exposure to the weakest CRE subsectors varies by bank, those with more than 100% of their capital in these buckets are more likely to be smaller regional entities,” the JPMorgan report stated, noting that Webster Financial Corporation, Valley National Bancorp, and Zions Bancorporation are a few of the banks with exposures exceeding 100% of their capital.

The bank’s base case scenario “assumes that aggregate CRE prices fall approximately 10% to 15% in the current cycle,” although for the office sector, the report revealed that price declines of 30% to 40% in the most stressed markets would be unsurprising.