8 Takeaways from Kevin Warsh’s First Semiannual Testimony to Congress

Newly confirmed Federal Reserve Chairman Kevin Warsh appeared before the House Financial Services Committee and the Senate Banking Committee this week to deliver his first semiannual testimony. Throughout two days of hearings, Chairman Warsh emphasized aligning finalized capital rules with domestic growth, streamlining thresholds for a diverse banking ecosystem, protecting traditional liquidity facilities from novel digital asset risks and implementing rigorous safety protocols for advanced AI.

Here are some takeaways from the hearing:

1. Supporting U.S. economic growth will be a priority as banking regulators finalize the Basel capital rule.

Sen. Mike Rounds (R-ND): “I think you and Vice Chairman Bowman and the respective financial regulators, I think you’ve done a good in terms of your roles with regard to the Basel III reproposal that was issued this March. The 2023 proposal would have substantially increased common equity capital requirements for Category I and Category II banks by approximately 19 percent, failing to strike a balance between maintaining resiliency of our banking system and doing so without hampering lending. I think this is a really critical item, and next to what artificial intelligence is going to do in terms of our productivity, I think it’s one of the biggest issues out there. With the June 18th comment deadline now behind us, are there any other categories of feedback that you’re weighing more heavily than others, such as the adjustments to leverage ratios or anything along that line? And if I could, is there going to be a go-live date this year sometime? Any idea when you might actually be able to talk about the when this thing is going to go public for us?”

Fed Chair Kevin Warsh: “Well, thank you for your question on supervision regulation. As I mentioned before, I’ve shown up with a lot of ideas for reform, not just in monetary policy, but in supervision and regulation too. When I was before this committee some 20 years ago, there was a debate about what the Basel process should be. Boy, we should get to the bottom of that 20 years later, and we should end up with a set of reforms in the United States that makes our financial system and our banks safer, sounder and more competitive. It’s that competition which provides better and more agile credit to the real economy. The Basel Endgame, senator, is not America’s Endgame. I am happy to work with international regulators to try to find common views, but we’re going to do the right thing for the U.S. economy. As you mentioned, we’re out for public comment. I’ll be very interested in the comments before we go final with a with a proposed final rule.”

2. A tailored supervisory framework is essential to maintaining a highly competitive, diversified banking system.

Rep. Roger Williams (R-TX): “So, my question would be: Can you tell us how you think the Federal Reserve’s supervisory role can promote a safe and sound banking system? While ensuring businesses and families continue to have access to credit they need to pursue the American dream.”

Fed Chair Kevin Warsh: “That’s a great question, Congressman. I’d say two broad things. One is we need a highly competitive, diversified banking system. This is the secret, one of the unheralded secrets of the U.S. economy. Our banking system is larger, a number of institutions of various sizes serve different constituencies. I think part of the reason why the U.S. has grown faster than our G7 and G20 colleagues is because the banking system here is fundamentally different. Secondly, what I would say about how we do that is we need to have tailored regulation that befits the kind of institution and the customers that they’re treating. One size does not fit all. And finally, I’d say I am all for international coordination of banking standards. It is a useful effort, so that we meet in Basel to try to come to some international standards. But the Basel Endgame is not Americans’ Endgame. That is not the Federal Reserve’s Endgame. Our Endgame is ensuring that we have the right rules that befit our economy, so that we have a safe, sound, and competitive banking system, and anything we agree on with international counterparts have to be in service of the American economy.”

4. Decisions regarding access to payment infrastructure will remain strictly grounded in independent risk management, safety and soundness assessments.

Rep. Gregory Meeks (D – NY): “Now I want you to know that I support innovation, but I also believe that the Federal Reserve has a responsibility to protect the integrity of our payment system from political pressure and short-term enthusiasm, and I believe that the administration has made expanding access to fintech and digital asset firms a clear priority of his. But the Federal Reserve has long evaluated access to its payment infrastructure based on safety and soundness, operational resilience, effective risk management and the stability of the financial system, not politics, not political priorities. And I should say this also, because what I’m concerned about is that they are firms that’s connected to our nation’s payment infrastructure that must have robust cybersecurity, fraud prevention, compliance and operational controls because failures can undermine public confidence in the financial system and leave consumers exposed to significant harm. So my question is, can you commit that decisions about access to the Federal Reserve’s payment rails will remain grounded solely in the Fed’s independent assessment of systemic risk, safety and soundness, and not political direction?”

Fed Chair Kevin Warsh: “We’re going to keep politics out of the Fed. We’re going to stay focused on the responsibilities you’ve given us, and I think you highlight something very important. This new technology revolution, which is hitting the Federal Reserve and the economy, provides huge opportunities. The United States can lead in payments. Our economy can be the strongest in the world and improve its growth rate, but it’s not without risks, and we at the Fed are going to strike the right balance between the challenges and the opportunities in payments and more broadly.”

5. Updating outdated tailoring thresholds remains a priority to keep regulatory frameworks aligned with a diverse banking ecosystem.

Sen. Katie Britt (R-AL): “And I’m going to follow up on a question that the chairman asked. I’d like to get you to kind of dig into this. Some banks are already approaching and crossing into new tailoring categories, and they’re making staffing and compliance and long-term business decisions, based on thresholds that haven’t been updated since 2019. At the same time, the Federal Reserve continues to rely on those categories and other regulatory frameworks. So my question is, how are you thinking about updating these tailoring frameworks when it comes to what banks can expect to see and proposals in the future?”

Fed Chair Kevin Warsh: “So it’s a great question, one I take seriously. To be candid with you and the chairman, the other members of the committee, monetary policy has distracted me a bit in the first seven weeks, but the Federal Reserve Chairman is supposed to be the chairman of monetary policy and payments and consumer affairs and supervision regulation, but I can tell you this: Vice Chairman Bowman has been working on these initiatives. She has briefed me about them, and broadly, I’ll step back and say, modernizing our banking system, streamlining regulations so that the rules that apply to the systemically important financial institutions are not one size fits all for every other. The secret to the American economy is we have a few thousand banks and other providers of credit who know their smaller markets [better]. I’d rather have that system than what most of our G20 peers have, where they have a half a dozen institutions implicitly backed by their government. I think reform is coming to supervision and regulation. I have my own ideas that might be as dramatic as I’ve already shared on monetary policy here, and I think the sooner we can get to the bottom of it, the better. If I could say one more thing, the reforms we’ve been putting in place over the last 15 years, coming out of Dodd Frank, as we learned in the Silicon Valley Bank example and the First Republic example, they didn’t work perfectly. My predecessors had very little choice but then to do another overall bailout. We don’t want that to happen again. So we want to tailor the rules and the capital so they serve the best interests of the U.S. economy, which I describe as a system that is safe, sound and competitive.”

6. Eliminating subjective “reputational risk” metrics from examiner guidance safeguards supervisory neutrality and promotes broad access to banking services.

Rep. Barry Loudermilk (R-GA): “First I want to talk about Operation Chokepoint. As you are fully aware, Operation Chokepoint 2.0 involved partisan actors at the Fed using quote reputation risk as a means to target and debank firms and individuals in the digital asset ecosystem, the energy industry, and really anyone that partisan actors that the Fed believed unworthy of a bank account or loan. This was especially egregious, given the fact that the Fed does not have a statutory authority from Congress to supervise for reputation risk. While I’m happy that reputation risk has been wiped from the Fed’s guidance to examiners, can you please tell us what steps the Fed can take to durably ensure that statutory silence is never again abused by partisan actors to attempt through the Fed what they cannot make through law in Congress, and also what actions that you may be taking?”

Fed Chair Kevin Warsh: “Thank you, Congressman. Reputational risk has been removed from the dashboard that supervisors and regulators will have anything to do with. My view is that being a good supervisor and regulator is tough business, and we don’t need to make it harder by bringing politics into it. Vice Chair Bowman has begun a series of reforms before I arrived in this, and I think you’re going to find in the coming quarters and years we’re going to continue to reform and refine our regulatory system so that we can have a safer and sounder financial system, and I’ll add a more competitive one too.”

7. Proactive collaboration on advanced AI security strengthens the ability of all financial institutions to defend against sophisticated cyber threats.

Sen. Jack Reed (D-RI): “AI is making huge impact on everything we do, particularly the banking system. And as you are aware, an interagency governmental group, Congress, Treasury, Energy et cetera, has authorized the major banks, the eight major banks, to use Mythos to evaluate their security. Would you agree that it’s important for all financial institutions to have access to these types of AI tools, so that they could analyze their operations for cyber vulnerabilities?”

Fed Chair Kevin Warsh: “Yes, I think the broad financial system has new vulnerabilities with these new technologies. I wouldn’t want to just isolate Mythos, though. The other large language models have rival products. The changes, the efficient frontier has changed even in the last month. But as these new models find their way more broadly, our banking system and, frankly, the Federal Reserve needs to do all we can to patch any vulnerabilities that we have.”

Sen. Jack Reed (D-RI): “What are you doing to ensure that these mid-sized and smaller banking institutions have access to whatever AI tools appropriate as quickly as possible?”

Fed Chair Kevin Warsh: “Yeah, so I share the sentiment, Senator Reed. We are not the deciders as to who has access, but I have not been shy in sharing my views with authorities across the government about the vulnerabilities, and have been asking for access not just for the Federal Reserve but for other institutions to a whole range of these new artificial intelligence models so that they can protect themselves. If you said to me what worries you over the course of the next several months, I want to make sure that we’re as protected as we can be from foreign actors that want to do us harm.”

8. The rapid expansion of frontier AI capabilities requires a proactive approach to identifying and mitigating systemic operational risks.

Sen. Mark Warner (D-VA): “Now, Senator Reed asked a very good question about Mythos, and I 100% agree. Mythos is already yesterday’s news because these models are coming out so quickly, and they pose such security risks. I think it’s incumbent because of the risk it provides to our financial system that at some point you’re going to be, and I’m asking you now, I think personally, I believe we need some level of mandatory testing pre-release because of the potentially draconian and dramatic effects. Now, how long? Who’s on that panel is critical. But what do you think about pretesting release regime going forward? More than just the voluntary willingness of a company to come forward.”

Fed Chair Kevin Warsh: “Yeah. So two things. First, these models are in their capabilities are growing at an exponential rate. In technology we would say hyper Moore’s law, wasn’t long ago people sitting in my position thought that the U.S. was a time of secular stagnation. All the good stuff had been invented. Boy, that seems awfully anachronistic. We’re moving fast. So what can we do? I don’t have as currently structured decision rights as to who has access, but I do have a bully pulpit, as you mentioned, and I’m unafraid to share my views with the Treasury Secretary and others. The cutting edge is moving very quickly. Key institutions are vulnerable. The sooner they can mitigate their vulnerabilities, the better. I’m looking forward to –“

Sen. Mark Warner (D-VA): “I hope that you will be willing to advocate moving on beyond a voluntary regime because the downside risk.”