Rationalizing Federal Reserve Examination Practices: A Return to the Law
As the Treasury Department and federal banking agencies consider how to rationalize the bank examination process, the simplest and most effective remedy would be for the Federal Reserve to conform its examination practices to law.
State of play: The current state of overlapping, and sometimes conflicting, federal bank examination renders banks distracted or disabled from the core business of lending as they devote time and resources to compliance rather than their economic mission.
Outside the law:
- Federal statute places limits on what the Federal Reserve is authorized to examine at a bank holding company.
- Its examinations are to focus only on gaining an overall understanding of the company and assessing those risks that pose a threat to the company’s safety and soundness or to the nation’s financial stability.
- Even for those risks, the Federal Reserve is directed to rely “to the fullest extent possible” on examinations by the OCC, FDIC, SEC, and CFTC.
- It is authorized to examine for violations of law, but only for a narrow set of specified laws; it is expressly prohibited from examining larger institutions for consumer compliance, as Congress gave that authority to the CFPB.
- In practice, Federal Reserve examiners violate all of these restrictions, routinely examining all manner of operations across holding company subsidiaries, with little to no regard to materiality or jurisdictional boundaries.
- The vast majority of holding company examination resources are now devoted to issues that pose no threat to safety and soundness — issues such as management of vendors performing inessential services; all aspects of the combined firm’s operations, policies and procedures regardless of materiality; information management systems; internal reporting systems; oversight of all models used across the firm regardless of function or importance; employee compensation and promotions; and board and management committee staffing and reporting.
- Federal Reserve examiners generally recognize no difference between the holding company and bank level. They routinely duplicate OCC and FDIC examinations in areas such as credit underwriting and cyber risk. They duplicate the SEC’s examinations of broker-dealers.
- Conforming to law would allow Federal Reserve examiners to focus on enterprise-wide capital and liquidity robustness and interest rate risk — the risks assigned to them by Congress.
Reforming Federal Reserve examination practices would eliminate significant duplication of efforts and free up resources to benefit American consumers and businesses.
Five Key Things
1. Fed Proposes Reforms to Large-Bank Ratings Framework
The Federal Reserve on Thursday issued a proposal seeking comment on its rating system for large banks, known as the Large Financial Institutions (LFI) framework. The ratings scheme complements the CAMELS rating system as a key metric by which federal examiners evaluate banks’ safety and soundness, capital, liquidity and other measures. The Fed proposal would amend the framework so that banks with only one “deficient-1” rating in the three rating components would still be considered “well-managed”; the loss of “well-managed” status confers several restrictions, including potential limits on mergers and growth. Under the current system, i The proposed change would align the ratings more closely with the actual condition of the banking sector, according to the proposal.
- Key quote: A factor underpinning the proposal is that one low rating among several components does not necessarily indicate a poorly managed bank; rather, it may signify an isolated issue with one aspect of the business or with a more subjective component of the framework like “governance and controls”. “In using the rating system, the Board has observed that a single Deficient-1 component rating can be indicative of a discrete deficiency that does not necessarily reflect the overall condition of a firm,” the proposal states. “For example, firms may be rated Deficient-1 on governance and controls due to concerns surrounding a specific operational risk management issue, including weaknesses in areas such as operational resilience, cybersecurity, or Bank Secrecy Act and anti-money laundering compliance. Similarly, firms may be rated Deficient-1 for capital or liquidity due to risk-management deficiencies in a particular business line. While such deficiencies may require significant management attention to address, such a deficiency could be discrete, and the firm could have strong positions and practices overall.”
- BPI response: BPI President and CEO Greg Baer issued a statement in response to the proposal: “Today’s proposed reform is overdue but welcome. It never made sense to measure a bank’s overall health based solely on the lowest-performing criteria. That approach inevitably led to two-thirds of large U.S. banks receiving an overall unsatisfactory rating, even if they were strong in every other category. We urge the board to finalize this reform expeditiously and then join the other banking agencies in making a parallel change to the CAMELS rating system for banks.”
2. Gould Confirmed to Lead OCC
The Senate on Thursday confirmed Jonathan Gould, a former senior OCC official and attorney, as Comptroller of the Currency. The vote was 50-45.
3. No, the eSLR Proposal Doesn’t Undermine Bank Resilience
Federal banking regulators recently proposed changes to the enhanced supplementary leverage ratio, which currently applies to the 8 U.S. GSIBs. The proposal will result in a non-material decrease in aggregate bank capital requirements of about 0.74%, according to the most recent available data.
Despite this modest change, recent commentary argues that this proposal will make banks less resilient by lowering leverage capital requirements at bank subsidiaries. These latest assertions cite a 27% reduction in capital at the insured depository institution subsidiary under the proposal, which we’ve previously demonstrated is misleading. They also fail to account for the strict legal and supervisory constraints that continue to govern and restrict capital movements for both bank holding companies and their subsidiaries. Learn more here.
4. Media Report: Hill Likely to Get FDIC Nomination
The White House is expected to nominate Acting FDIC Chair Travis Hill to the agency’s permanent leadership slot, according to Capitol Account this week. Hill, the agency’s former vice chair and a previous Senate Banking Committee staffer, has outlined several policy agenda items in his tenure as acting chair, including capital and supervision reforms. If the nomination proceeds, it would bring the federal banking agencies closer to a permanent slate of regulatory principals, including Vice Chair for Supervision Michelle Bowman and OCC nominee Jonathan Gould.
5. Bank Resolution Planning Should Promote Preparedness, Not Paperwork
Earlier this month, several banks submitted detailed plans to regulators explaining how they would be resolved in a failure. This recurring ritual involves resolution plans that can span tens of thousands of pages. Recent history – such as the failures of Silicon Valley Bank, Signature Bank and Credit Suisse – suggests these expansive plans are unnecessary to improve readiness and could distract from real preparedness. “Much like disaster preparedness, resolution readiness requires both individuals and emergency responders to be prepared for fast and effective action,” BPI’s Tabitha Edgens wrote in a recent BankThink op-ed. “Bank-prepared resolution plans are one piece of the response tool kit. But equally important is how resolution authorities use them when put to the test.” Read more here.
In Case You Missed It
Judge Rejects Fintech, Consumer Groups’ Amicus Bids
Federal Judge Danny Reeves this week rejected four separate attempts by several different fintech and consumer groups to file amicus briefs in support of the fintech industry’s defense of the CFPB’s Section 1033 rule. One of the proposed briefs, by the American Fintech Council, “largely addresses the same issues raised” by the Financial Technology Association, the fintech industry intervenor in the case, according to Reeves. In response to the AFC’s proposed brief, which misleadingly portrayed the banking industry as divided on the issue of data sharing, BPI’s Paige Pidano Paridon said: “Banks of all sizes have partnered with fintechs for years to enable consumers to safely share data, including through initiatives like the Financial Data Exchange, to create common standards that support competition and protect consumer privacy and data security. The American Fintech Council recognized the value of this work when it joined this initiative in April, and we encourage them to stand behind their commitment to industry collaboration and common standards rather than advancing baseless claims about BPI member banks’ unwillingness to engage constructively as a means to defend an unlawful regulation.”
What’s on the FDIC’s Agenda
The FDIC will hold an open meeting next week on Tuesday, July 15, according to a public notice this week. On the meeting agenda are several regulatory matters, including: proposed revised guidelines for supervisory appeals; a proposal to adjust and index regulatory thresholds; and a request for information on industrial loan companies. The FDIC board will also vote on other matters without major discussion, including a proposal on Community Reinvestment Act regulations.
The Crypto Ledger
Here’s the latest in crypto.
- Senate hearing: The Senate Banking Committee held a hearing this week to discuss crypto market structure legislation, the next project on its digital asset agenda after the passage of the GENIUS Act stablecoin bill. The hearing featured academics, former regulators and crypto industry representatives. Senators raised various policy issues under consideration, including illicit finance, money laundering and sanctions evasion. Chairman Tim Scott (R-SC) called for policies that enable U.S. dominance in digital asset technology. Witness Timothy Massad, former CFTC chairman, warned that the same concerns are recurring with several iterations of crypto regulation attempts: “There have been repeated congressional hearings calling for clarity in a series of legislative proposals, each claiming to provide clarity, but there’s never been a consensus,” he said. “And whether it’s Lummis-Gillibrand, FIT 21 or the CLARITY Act, they all have similar flaws,” including a fragmented regulatory system. Other witnesses discussed where to draw lines between securities and commodities. Senators discussed the relative risk of money laundering between digital assets and cash. Sen. Catherine Cortez Masto (D-NV) raised concerns about scams and fraud.
- What’s next: The Senate Agriculture Committee will hold a hearing on market structure legislation next week on July 15.
- Tether: a money launderer’s dream: A recent article in The Economist reveals how stablecoin Tether became “money-launderers’ dream currency.” The article details Tether’s role in complex global criminal networks that span from Russian hackers to British drug gangs.
Global Patchwork of Prudential Rules Undermines Resilience, Hurts Economic Growth
Fragmentation in global financial regulation puts competition, economic growth and financial system resilience at risk, says a joint paper published this week by the Bank Policy Institute, GFMA and the Institute of International Finance.
“Fragmentation resulting from miscalibration of global standards or excessive regulatory and supervisory divergence can trap capital, liquidity and risk in local markets; create significant financial and operational inefficiencies resulting in additional unnecessary costs to end-users; reduce the capacity of financial firms to serve both domestic and international customers; and may increase fragility, making markets more brittle and less resilient,” the trades wrote in the paper.
A 2018 OECD survey estimated that a piecemeal approach to financial sector regulation costs the global economy about $780 billion each year. The World Economic Forum estimates that fragmentation could reduce global output by as much as $5.7 trillion annually, depending on the degree of fragmentation. That’s equivalent to 5% of world GDP and twice the losses seen during the COVID-19 pandemic.
Global standard-setters, including the Financial Stability Board, International Organization of Securities Commissions and others, initiated a review in 2018 to identify ways to address market fragmentation. Yet despite these efforts, fragmentation continues to increase.
Four recommendations to address fragmentation:
- Identify policies that force subsidiarization. The International Monetary Fund, FSB and Basel Committee on Banking Supervision should identify national rules that require financial institutions to establish local subsidiaries or restrict branch operations.
- Reassess ring-fencing requirements. Jurisdictions with ring-fencing requirements should review whether those rules are properly calibrated considering the post-crisis resolution framework, including resolution planning and enhanced loss absorbency requirements.
- Improve global coordination and cooperation. Global standard-setters and regulators should work with industry and among themselves to address fragmentation and risks introduced by inconsistencies.
- Re-evaluate supervisory colleges and case management groups. The FSB should re-evaluate the functioning of international colleges and case management groups. These groups are supposed to bring together regulators from different countries to oversee global financial institutions, and it would be useful to examine these initiatives and whether they are meeting this goal effectively.
To access a copy of the paper, please click here.
Traversing the Pond
Here’s what’s new in international banking policy.
- BoE capital review: The Bank of England will review the overall level of bank capital requirements for the first time in six years, according to the central bank’s Financial Stability Report released this week. The action comes as BoE officials determined that banks have maintained adequate capital under stress for much of the past decade. Indeed, the current report assessed that “…the UK banking system remains well capitalized and has high levels of liquidity…”
- Other highlights: Other notable takeaways from the BoE’s report include a focus on promoting economic growth. The report notes ongoing policy debates around financial regulation in various global jurisdictions. “Alongside the increase in global risks, the appropriateness of financial regulation is being debated actively across a number of jurisdictions. Robust regulatory standards and international co-operation support sustainable economic growth over the long term.” The report also suggests “supporting the work of UK authorities to tackle the negative effects of climate change on growth,” and urges the industry and global policymakers to focus on information-sharing and building resilience amid heightened cybersecurity risk.
- Key quote from the report: “Risks and uncertainty associated with geopolitical tensions, global fragmentation of trade and financial markets, and pressures on sovereign debt markets are still elevated. Some geopolitical risks have crystalised. Related to this, material uncertainty around the global macroeconomic outlook persists. As an open economy with a large financial sector, these risks are particularly relevant to UK financial stability.”
- FSB recommendations on nonbank financial firms: The Financial Stability Board recently published its final report offering recommendations on nonbank financial institutions and leverage. The report has been in the works since the March 2020 market turmoil. The FSB is currently focusing on monitoring and assessing vulnerabilities in the nonbank financial sector, addressing data challenges, discussing various authorities’ policy approaches to enhancing resilience in the sector and evaluating the effects of policies in the area. The report addresses the financial stability risks created by nonbank financial intermediary leverage, focusing on risks that could arise in critical financial markets and risks created through interconnections between nonbanks and systemically important banks. It sets out an integrated approach to addressing such risks.
- ECB on macroprudential policy: The European Central Bank this week released its statement on macroprudential policies, including “releasable” capital buffers like the countercyclical capital buffer. The ECB’s statement advised national authorities to maintain their existing capital buffer requirements (as opposed to reducing them), saying these are crucial for preserving banking sector resilience.
- Von der Leyen vote: European Commission President Ursula von der Leyen weathered a no-confidence vote on her leadership this week, winning the backing of a majority of European Parliament members. A far-right faction had attempted to oust von der Leyen from the EU’s top leadership role. 360 MEPs voted against the motion, with 175 in favor and 18 abstaining. Of 720 MEPs, 553 showed up to cast a ballot. The motion would have required 357 votes to pass.
Wells Fargo Donates $1 Million Toward Flood Relief Efforts in Texas
Wells Fargo on Wednesday announced a $1 million donation toward immediate relief and long-term recovery efforts for the recent severe floods in Texas. Funding will support the Community Foundation of the Texas Hill Country (Kerr County Relief Fund), Texas Search and Rescue (TEXSAR), Austin Disaster Relief Network and LiftFund.
