By Phillip Basil, Better Markets Director of Banking Policy (Published in Law360, October 7, 2021)
The last four years were bad for bank supervision and regulation. The priorities were to weaken regulations and to soften supervision to make it fairer and less assertive to banks.
Indeed, as a Wall Street Journal headline put it in 2018, “Banks Get Kinder, Gentler Treatment Under Trump.” With a vice chair for supervision appointed by then-President Donald Trump pushing the Federal Reserve’s supervision and regulation priorities since 2017, a dangerous deregulatory agenda and a restrained supervisory program were implemented with the support of Fed Chair Jerome Powell and others, although opposed by Fed Gov. Lael Brainard.
That agenda was broad-based and targeted nearly all of the most impactful post-financial crisis regulations. Foundational components of individual regulations were selectively removed or eroded, obscuring the effect to some observers, but nonetheless materially weakening the supervision and regulation of large banks.
The term of the current vice chair for supervision, Randal Quarles, expires on Oct. 13, giving President Joe Biden a tremendous opportunity not only to undo the deregulation of the banking system, but also to address new and emerging threats. Done right, the next vice chair for supervision can rebuild a solid foundation for the future of supervision and regulation at the Fed.
While there is much focus on who Biden will nominate as the next chair of the Fed, the vice chair for supervision position has significant importance for financial stability, the safety of the U.S. banking system, and the standard of living of all Americans who pay the price for crashes in lost jobs, homes, savings and so much more.
The vice chair for supervision is the head of the Fed’s Division of Supervision and Regulation, which can have tremendous influence over the setting of rules for, and supervisory oversight of, the U.S. banking system. The vice chair is also an important member of the Financial Stability Board and a key U.S. representative to the Basel Committee on Banking Supervision, both of which work to set international standards.
The next vice chair for supervision must use all platforms of the position to immediately commence re-regulating the banking system to promote a safer financial system by more fully addressing the challenges presented by institutions deemed “too big to fail,” which have grown larger and more dangerous.
This starts with undoing the most dangerous deregulation carried out since 2017. The Fed’s supervisory stress test must be strengthened and made more dynamic. Sensible, impactful assumptions that were removed must be reinstated, and the scenarios need to be varied in order to capture emerging, salient risks.
Since last year, the stress test has been integrated into large banks’ real-time capital requirements, and the only thing standing between a failing bank and a taxpayer bailout is loss-absorbing capital.
As part of stress-test-related capital requirements, a post-stress leverage requirement must be restored. Such a requirement would ensure that banks are able to meet minimum leverage requirements — which prevent large bank balance sheets from growing too large, relative to capital levels — even after accounting for the losses estimated in the stress test.
Prior to its removal, the post-stress leverage requirement had, at times, resulted in the highest level of required capital for many large banks compared to the post-stress capital requirements that remain in place.
The almost surgical weakening of liquidity requirements, which are essential to prevent cash shortages that can exacerbate a crisis, must be reversed. The unnecessary and unjustifiable reduction of liquidity requirements for large banks with between $250 billion and $700 billion in assets should be undone.
Additionally, the net stable funding ratio liquidity regulation should be reverted to its originally proposed form, prior to the exclusions, limitations and other unnecessary modifications included in the final rule passed in the Trump era.
The original form of the Volcker Rule’s ban on high-risk, dangerous proprietary trading should be adopted, and made broader and stronger. And the Fed should reinstate the requirement for the posting of collateral on derivative transactions between a bank and its affiliates.
Other key regulations should be strengthened to go even further than they had in their initial form.
Making large banks prepare for possible resolution is critical to addressing the “too big to fail” problem, so the submission of so-called living wills should return to a two-year cycle to increase their timeliness. In addition, many of the Fed’s resolution plan expectations should be made part of legally constraining rules, rather than part of nonbinding supervisory guidance.
Additionally, the pandemic-caused financial and economic stress, as well as the 2008 financial crisis, have highlighted issues that should be addressed by further enhancements of regulatory requirements.
For example, in both events, money market funds proved to be a source of fragility and material risk. Such issues highlight that capital requirements for large banks should be higher, and that the Fed should rethink its capital requirements.
More generally, the next vice chair for supervision should assess what other modifications could be made to the regulatory framework to enhance the safety and soundness of the banking system.
On the bank supervision front, the effective elimination of the so-called Comprehensive Capital Analysis and Review qualitative objection — which allowed the Fed to limit or stop distributions and share buybacks based on supervisory findings — significantly weakened the effectiveness of large bank supervision, and its use should be fully restored.
Supervisory assessments should be expanded at the largest banks to include a greater, explicit focus on the effectiveness of boards of directors, and consideration should be given to requiring independent board chairs, rather than allowing CEOs to also be board chairs.
To provide stronger incentives to banks and ensure public accountability not only of the banks but of the Fed itself, the supervisory process must be made more transparent, including by increasing the usage of public enforcement actions.
Importantly, the supervisory assessment framework must also include assessments on issues related to climate change. As the key supervisory agency of the banking system, with its mandate to maintain the stability of the U.S. financial system, the Fed must move its climate-related efforts along substantially.
At the very least, it should publicly communicate to banks that their ability to appropriately identify, measure, control and monitor all of their material climate-related risks will be an important part of the Fed’s supervisory assessments.
Stress testing/scenario analysis should also be used to inform supervisors of banks’ climate risks.
The climate crisis threatens to impact every aspect of the economy and financial system, and the Fed must take those threats seriously.
In addition to promoting a safer banking system, the next vice chair for supervision must work to improve the economic well-being of low- to moderate-income communities, including communities of color, by promoting increased access to credit and other financial services.
Closing economic racial disparities is imperative. A key way this can be accomplished is through thoughtful changes that improve, strengthen and broaden regulations related to the Community Reinvestment Act.
The Fed, along with the other regulatory agencies, should closely monitor fees charged by banks for various financial services and other factors, such as required checking account minimums, to determine the best way to encourage banks to make banking fair and accessible.
There are also new and emerging risks to assess and address. The pandemic-related stress highlighted the risks from a nonbank financial system that has increased in size and interconnectedness. And the rise of financial technology companies has altered the dynamics of the banking system and introduced competition that is broadly unregulated.
Fintech can’t be allowed to be the latest label to obscure yet more creative ways to extract money from financial consumers while increasing systemic risk.
The right set of actions by the next vice chair for supervision will get the Fed back on the path of finishing the job started by the Dodd-Frank Act to address the “too big to fail” problem, help ensure greater resiliency of our financial system now and in the future, and promote a financial system that supports an inclusive economy that works better for all Americans.
Phillip Basil is director of banking policy at Better Markets, Inc.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the organization, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.