The Federal Reserve’s Proposed New LFI Rating System Is a Welcome Development

The Federal Reserve’s Proposed New LFI Rating System Is a Welcome Development

As we’ve noted in the past, current rating systems for banks – and in particular the CAMELS system that has been in place (with little change) since 1979 – have significant shortcomings, are outdated, and in urgent need of review and improvement.  (See here and here.)  Most important, the CAMELS system fails to embrace the three key characteristics of an optimal rating system:  namely that it should have a clearly articulated purpose, be objective and transparent, and rely on specific and measurable standards that reflect that purpose and produce consistent and predictable supervisory assessments.  As we highlight in our recent comment letter, the Federal Reserve’s recent proposal to establish a new rating system for large bank holding companies – what it terms large financial institutions, or LFIs—is a significant and important step towards a new ratings paradigm that meets those criteria.

Overview of the Fed’s LFI Proposal

The Federal Reserve’s new proposed rating framework would replace the current RFI/C(D) rating system[1] used for bank holding companies.  This RFI/C(D) framework suffers from some, although not all of the problems with the CAMELS framework, including that it has not been reviewed or revised in almost fifteen years and is thus outdated.  The new system is composed of three component categories, Capital Planning and Positions, Liquidity Risk Management and Positions, and Governance and Controls.  The new framework uses a multi-level ratings scale that is composed of (i) Satisfactory and Satisfactory Watch, a transitory rating used to convey supervisory concerns to be addressed by institutions, (ii) Deficient-1 and (iii) Deficient-2, where a Deficient rating would result in negative regulatory consequences, including the loss of well-managed status.[2]  In contrast to the RFI/C(D) and the CAMELS frameworks, the LFI rating system recognizes the use and importance of the post-crisis sophisticated capital and liquidity rules and assessments, such as CCAR and CLAR.

The proposed LFI rating system’s purposes are clearly articulated and exactly appropriate: (i) to “provide[] a supervisory evaluation of whether a firm possesses sufficient financial and operational strength and resilience to maintain safe and sound operations through a range of conditions”;[3] (ii) to “[e]nhance the clarity and consistency of supervisory assessments and communications of supervisory findings and implications”;[4] and (iii) to “reduc[e] the probability of LFIs failing or experiencing material distress and reducing the risk to U.S. financial stability.”[5]  Importantly, these articulated purposes are uniformly focused on core questions of safety and soundness and core principles of regulatory clarity and certainty.

The proposal also aims to enhance the objectivity and transparency of the Federal Reserve’s supervisory expectations and practices, consistent with the requirements of administrative law, while allowing the application of those expectations to reflect the variety of ways in which firms may meet supervisory expectations in light of their different business models, activities, and risk profiles.

Improving on the Fed’s Proposal

While each of these developments is a major improvement, there is room for further refinements.  To that end, our comment letter include a range of concrete recommendations that we believe would help ensure that the new rating system is as clear and objective as possible and achieves its safety and soundness goals. We highlight three of those suggestions here.

  1. Establishment of a Transitory Rating to Convey Supervisory Concerns to the Institution The proposed framework would establish a transitory rating – Satisfactory Watch – that would be used to convey supervisory concerns that an institution must address in order to avoid a further rating downgrade and related regulatory implications.  This transitory rating is a welcome and positive change from the current approach whereby institutions may be subjected to ratings downgrades that have substantial regulatory implications before they have had the opportunity to fully address an issue. While a good development in principle, there are problems with the way in which the proposed Satisfactory Watch rating would function in practice.  In particular, the proposal would require identified issues to be fully resolved within a “specified timeframe . . . generally no longer than 18 months”[6]before the firm would be downgraded if it failed to remediate the identified issues.  The consequences of such an automatic trigger would be severe because, as proposed, a rating of less than Satisfactory Watch in any single component would result in the loss of the firm’s “well managed” status, which would hinder a firm’s ability to engage in new or expansionary activities. 

    A firm should not face an automatic rating downgrade based on the passage of a general timeframe if it is working in good faith to remediate an issue and demonstrates reasonable progress toward fully resolving the issue. 

  2. Loss of Well-Managed Status A rating of less than Satisfactory Watch in any single component would result in the loss of the firm’s “well managed” status, which would severely curtail an institution’s ability to engage in new or expansionary activities.  Thus, under the proposal, management would be separately assessed in, and “well managed” status is essentially a function of, each separate component rating category.  Rather than functioning as an automatic consequence of any one component rating, a firm’s “well managed” status should be the result of a holistic assessment of the institution, which could be achieved in a variety of ways.  One option would be to retain a composite rating, which could be used as the basis for a firm’s “well managed” status.  However such a holistic assessment would be accomplished, it is critical that the Federal Reserve also establish clear and objective criteria and parameters for making these determinations in furtherance of its goals of implementing consistent and predictable supervisory assessments and outcomes. 
  3. Horizontal Reviews We also offer recommendations regarding horizontal supervisory assessments, which would be given more prominence under the new framework, consistent with the Federal Reserve’s increasing reliance on such assessments in recent years.  If conducted appropriately, the use of such horizontal reviews as a supervisory tool can produce meaningful benefits – in particular, they can both promote consistent supervisory assessments by on-site exam teams and communications of supervisory findings and facilitate supervisors’ understanding of the broader industry.  At the same time, however, the use of horizontal assessments can pose significant risks in practice, which we encourage the Federal Reserve to address both within and outside the LFI rating context. 

    If not conducted properly, there is a risk that horizontal reviews will be used not simply to gather information or assess compliance with existing policy, but instead to make and enforce policy.  Horizontal reviews should be used to gather information and assess compliance with already articulated standards; to the extent those reviews lead the Federal Reserve to conclude that new binding standards are needed, they should be established via notice and comment rulemaking and enforced thereafter, rather than ex post and retroactively.  There is also the risk that horizontal reviews may result in the application of “one size fits all” supervisory expectations across banking organizations.  Such expectations do not sufficiently account for different firms’ business models, risk profiles and other characteristics, but rather, are based on supervisory assessments of best practices at other firms.

Next Step:  A Public Reassessment of the CAMELS Framework

Given this important step that the Federal Reserve has taken to implement a more objective, transparent, and safety-and-soundness focused ratings framework, we are hopeful that the banking agencies jointly will in short order engage in a similar long-overdue public reassessment of the CAMELS framework.

[1] RFI/C(D) reflects the following categories:  Risk Management (R); Financial Condition (F); and potential Impact (I) of the parent company and nondepository subsidiaries on the subsidiary depository institution(s). A composite rating (C) is based on an evaluation and rating of its managerial and financial condition and an assessment of future potential risk to its subsidiary depository institution(s). The fourth component rating, Depository Institution (D), generally mirrors the primary regulator’s assessment of the subsidiary depository institution(s).  See Federal Reserve Supervisory Letter SR 04-08 (December 6, 2004).

[2] Federal Reserve System, Large Financial Institution Rating System; Regulations K and LL, 82 Fed. Reg. 39049 (Aug. 17, 2017).  Referenced throughout this letter as the “proposed LFI rating system” and, together with the supplementary information published in the Federal Register, the “proposal.”  LFIs would broadly include all bank holding companies with total consolidated assets of $50 billion or more; all non-insurance, noncommercial savings and loan holding companies with total consolidated assets of $50 billion or more; and U.S. intermediate holding companies of foreign banking organizations established pursuant to the Federal Reserve’s Regulation YY.  82 Fed. Reg. 39049, 39052.

[3] 82 Fed. Reg. 39049, 39050.

[4] 82 Fed. Reg. 39049, 39050.

[5] 82 Fed. Reg. 39049, 39050.

[6] 82 Fed. Reg. 39049, 39051.