A NEW CHAPTER IN STRESS TESTING
Speaking on November 9 at the Brookings Institution, Fed Vice Chairman for Supervision Randal Quarles discussed some of the changes the Fed has proposed to its stress testing program and how it is thinking about moving forward with those changes. Here are some key takeaways from Quarles's remarks:
- Delay in full implementation of the Stress Capital Buffer (SCB). Originally proposed by the Fed in April of this year and envisaged for implementation as part of the 2019 stress test cycle, the SCB is intended to simplify capital rules for large banks by replacing the current fixed buffer requirement of 2.5 percent of risk-weighted assets with one based on each firm's stress test results. While Quarles expects the SCB to ultimately be implemented, he noted that the public comments received on the Fed's initial proposed rule "have flagged certain elements of the regime that could benefit from further refinement." In response to those comments, Quarles anticipates that the Fed will adopt a final rule in the "near future" that will settle the basic framework of the SCB, but will also re-propose certain elements. As a consequence, Quarles does not expect that the first SCB will go into full effect before 2020. However, the Fed will consider whether it can move forward with certain aspects of the SCB proposal for CCAR 2019, such as assumptions related to balance sheet growth.
- Earlier notice of SCB. Quarles noted that he is sympathetic to the view expressed by firms that they "would be able to engage in more thoughtful capital planning" if they knew the results of that year's stress test (and resulting SCB) before finalizing their distribution plans for the upcoming year. Consequently, he intends to ask the Board to adjust the operation of the rule so that firms know their SCB before they decide on their planned distributions for the coming year.
- No 2019 testing for firms with less than $250 billion in assets. In light of the every-other-year cycle contemplated in the tailoring proposal that the Board approved in October, Quarles indicated that he anticipates asking the Board to exempt firms with less than $250 billion in assets from the CCAR quantitative assessment and supervisory stress testing in 2019.
- Increased transparency. Under the subheading of "Transparency," Quarles's speech notes that the Fed is developing a policy statement, anticipated for early 2019, providing more detail about stress test models and the scenario design process. This increased transparency will likely include publishing hypothetical loans and associated loss rates, which will help firms benchmark the results of their own models against those of the supervisory models.
- No more public shaming. Quarles said "the time has come to normalize the CCAR qualitative assessment by removing the public objection tool, and continuing to evaluate firms' stress testing practices through normal supervision."
Quarles faces Congressional questioning amid political turnover. Just days after his remarks on stress testing at the Brookings Institution, Quarles went to Capitol Hill to present his semiannual testimony on the Fed's supervision and regulation of the financial system. He spoke in a time of transition following the November 6 elections, in which Democrats regained the majority in the House for the first time in eight years. Appearing before the House Financial Services Committee on November 14 and the Senate Banking Committee a day later, Quarles often found himself on the defensive and got a taste of shifting Congressional oversight priorities, particularly on the House side. In his prepared testimony, and in exchanges with lawmakers, Quarles stressed the importance of transparency – both to provide clarity for regulated firms and to increase public confidence. His opening remarks also referenced the issuance of the Fed's first semiannual review of the safety and soundness of the US banking system (see Fed Report item below), and efforts to improve regulatory efficiency and tailor regulation and supervision based on actual levels of risk. And he discussed how the Fed is implementing the Dodd-Frank rollback law, officially known as the Economic Growth, Regulatory Relief and Consumer Protection Act, that was enacted this year with some bipartisan support in the Senate but was unpopular with most House Democrats. A consistent theme running through both days' hearings was that Democrats stressed the need not to weaken prudential requirements, while Republicans, who will still control the Senate next year, called for more regulatory relief. With Democrats no longer relegated to minority status in both chambers, the dynamics of House-Senate interactions on financial services issues will likely become more contentious starting early next year.
Some key takeaways from Quarles's two-day marathon on the Hill:
- A new agenda for the House. Representative Maxine Waters (D-CA), expected to assume the Financial Services Committee chair when the 116th Congress is sworn in in January, made clear that her priorities will represent a sharp turn from those of the current chairman, retiring Representative Jeb Hensarling (R-TX), and the Republican majority. "Make no mistake: come January in this committee, the days of this committee weakening regulations and putting our economy once again at risk of another financial crisis will come to an end," Waters said. She noted that Quarles's post was created "to help rectify the Fed's inadequate supervision and enforcement prior to the financial crisis" and stated, "It is essential that the Fed keeps a watchful eye on the financial institutions it supervises and makes strong use of its existing enforcement tools to crack down on institutions that break the law." For his part, Hensarling, who had sought to repeal rather than merely modify Dodd-Frank, opened last week's hearing by questioning the need for what he called "so-called 'heightened prudential standards'" and gave guarded praise to the Fed's initial implementation of the deregulation law passed this year with a new risk-based framework for large bank supervision as a modest first step. (See the November 5 edition of Bank Regulatory News and Trends.)
- Capital requirements for large banks. Noting that she and 18 other Financial Services Democrats in September wrote to the Fed to urge that strong capital requirements be maintained for G-SIBs, Waters sought assurances from Quarles that the Fed would not ease up on those rules for the biggest institutions. Quarles assured that "it is not our intention; indeed, it's the opposite of our intention to affect the total loss absorbing capacity of the largest firms."
- Bank governance. Waters, noting that the Fed's supervision and regulatory report indicates that there are 795 pending supervisory actions against the 12 biggest banks, asked if "megabanks are too large to manage." Quarles responded that, now that banks have improved their capital and liquidity, "they are turning their resources to addressing questions of governance" and that the numbers of MRAs and MRIAs about governance matters are decreasing and that trend is expected to continue.
- CECL. It was not only Democrats lobbing tough questions at Quarles. Representative Blaine Leutkemeyer (R-MO) pressed Quarles on the current expected credit losses, the accounting standard that replaces the allowance for loan and lease losses, which he said "fundamentally changes accounting practices" for small banks and represents an added cost of business that could result in a cutback of services offered to consumers. Quarles replied that for "those firms that are affected by the stress test, CECL could actually be a wash because to the extent that it means a larger reserve at the outset of the period of stress, then you'll chew through that reserve before you chew through other things in the stress test. And it can be a one-to-one offset." In an exchange with Senator Doug Jones (D-AL), who echoed the concerns about unintended consequences for small banks, Quarles said there would be a three-year phase-in so that regulators can better understand how the CECL works.
- CRA. Several members of both the House and Senate committees asked about the Community Reinvestment Act overhaul that has been proposed by OCC, but which the Fed and FDIC have not yet embraced. Quarles said he expected the three agencies to ultimately develop a joint rulemaking. He also indicated that he though the CRA "has become a little ossified and formulaic," but that he hopes there will be a "real reinvigoration" of the Act and that "we should not be weakening the CRA." Meanwhile, a group 11 Financial Services Committee centrist Democrats have called on the OCC to reconsider its CRA proposal, telling Comptroller Joseph Otting that his proposal is "overly prescriptive" and that "a purely numeric or quantitative framework" would not create the proper incentives for banks to lend more to lower-income Americans.
- BSA/AML. Quarles was also questioned by House members from both sides of the aisle about Bank Secrecy Act and anti-money laundering compliance issues, especially for small and community banks. He assured members that the Fed will be working with its supervisors and banks to help them understand their obligations and provide supportive resources to leverage new technologies to reduce compliance costs.
- Leveraged loans. Senator Elizabeth Warren (D-MA) asked Quarles what the Fed was doing about what she called the rapid growth of leveraged corporate lending. The senator pressed Quarles on whether the Fed was enforcing a 2013 Fed-FDIC-OCC joint guidance providing risk management and underwriting expectations for leveraged loans. While stressing that agency guidance documents are not enforceable, Quarles said the Fed is "monitoring compliance with safety and soundness." But Warren cited reports of banks offering loans that violate the 2013 guidance and compared the situation to the subprime mortgage market before the financial crisis, with loans packaged and sold to investors as collateralized loan obligations "which spread the risk throughout the system and take the lender off the hook for originating a bad loan." Quarles responded that the Fed is "monitoring carefully how the CLO ecosystem is evolving to make sure that we understand where risks are evolving there." But Warren said, "I'm not sure that I see much distinction between what you're doing now and what the Fed was doing pre-2008 and I think that's deeply worrisome." Warren also spelled out her concerns on the issue in a November 14 letter to the Fed and other regulators.
- Foreign banks. Partisan disagreements were also on display over the issue of the supervision of the US operations of foreign banks. Banking Committee Chairman Michael Crapo (R-ID), author of the Dodd-Frank rollback legislation, said he appreciated the Fed's steps thus far to implement provisions of the new law, but said the treatment of foreign banks was an issue that remained unaddressed. Quarles said that modernizing the resolution framework and tailoring regulations for FBOs was on the Fed's to-do list, but said he saw the issue as separate from implementation of the new law. For his part, Senator Sherrod Brown (D-OH), ranking member on the Banking Committee, said the Fed's proposals to implement the new law – which he called the "bank giveaway bill" – go beyond what lawmakers intended. "The Fed's proposal also promises more goodies for the big banks, with rollbacks for large foreign banks expected in the next few months," Brown said. "This is despite the fact that the Fed's own progress report said that foreign banks continue to violate anti-money laundering laws and skirt Dodd-Frank requirements."
Fed Report finds post-crisis regs have made US banks safer and more sound, but enforcement actions increase for FBOs. A new report from the Fed on its regulatory and supervisory activities found that banking industry profitability ratios are at their highest levels since 2007. The Fed Board released its inaugural Supervision and Regulation Report on November 9, summarizing banking conditions and the Fed's regulatory actions, in conjunction with Quarles's semiannual Congressional testimony. As the first in the series of reports, the document covers the period going back to the financial crisis, but future reports will focus on industry trends and regulations over the most recent reporting period. The report found that banks are generally showing steady improvement in capital planning and liquidity management. But it also notes that "material risk-management weaknesses persist at a number of firms." Areas of weakness for firms with less-than-satisfactory ratings include compliance, internal controls, model risk management, operational risk management, and data and IT infrastructure. In particular, the report cites difficulties with some firms' BSA/AML programs, which, it notes, tend to have longer remediation timelines. The report also indicates that "MRAs and MRIAs have actually increased for large foreign banking operations, reflecting changes in regulation that required substantive changes to their US structures." The report identifies its supervisory priorities for banks in different categories, including large financial institutions (LISCCs and LFBOs) and regional and community banking organizations (RBOs and CBOs). Priorities for larger firms include capital, liquidity, governance and controls and recovery and resolution planning. For regional and community banks, the Fed is prioritizing credit risk, operational risk, sales incentives, liquidity risk and BSA compliance. The report mostly includes data as of June 30, 2018.
Banking advocacy groups seek more formal assurance that guidance is nonbinding. Following a recent interagency statement from federal banking regulators that supervisory guidance does not have the force of law, two of the nation's leading banking industry organizations are calling on the agencies to institutionalize that position and ensure that examiners and other officials are bound by it. The Bank Policy Institute and the American Bankers Association on November 5 submitted letters petitioning the Fed, FDIC, OCC and CFPB for a formal rulemaking on supervisory guidance. Those four agencies, plus the NCUA, on September 11 jointly issued a statement clarifying that they do not take enforcement actions based on such guidance, which they said is meant only to express expectations, priorities and general views. But, as BPI President Greg Baer and ABA President Rob Nichols wrote, "of course, the Interagency Statement is itself only guidance, and thus may well be viewed by current or future agency staff as non-binding." Baer and Nichols said the explicit recognition that the requested rulemaking represents would "provide greater clarity to the examination process." They noted that failure to comply with guidance has often resulted in the issuance of Matters Requiring Attention that they said are "based on neither law nor regulation," but which nonetheless serve as "quasi-enforcement" actions. They also expressed concern that examiners might not consider the interagency statement to be retroactive. The petition calls on regulators to make clear that MRAs and similar enforcement findings be "based only on a violation of a statute, regulation or order," and not on a "generic or conclusory reference to 'safety and soundness.'"
Brainard warns banks and regulators on risks of AI. While noting that emerging artificial intelligence technologies offer many actual and potential beneficial applications for banking, Fed Board Governor Lael Brainard said that financial services "firms should be continually vigilant for new issues in the rapidly evolving area of AI." In a November 13 speech at the Fintech and the New Financial Landscape conference in Philadelphia, Brainard said the Fed's fintech working group is soliciting input from industry, banks, consumer advocates and researchers as it tries to better grasp the implications of machine learning technology – both for the industry and for the regulatory regime. Brainard, the sole remaining Board member appointed by President Obama, said the Fed and other responsible agencies are still grappling with how advances in AI fit in with existing laws and regulations and how to "facilitate an environment in which socially beneficial, responsible innovation can progress with appropriate mitigation of risk and consistent with applicable statutes and regulations." She cautioned that "firms should not assume that AI approaches are less susceptible to problems because they are purported to be able to 'learn' or less prone to human error," citing examples of AI not functioning as expected and creating unintended negative consequences. Brainard noted that AI approaches are attractive for banks because of their superior pattern recognition capabilities, cost efficiencies, greater accuracy and predictive power. These attributes of AI can be applied to fraud detection, credit quality and price insurance assessments, time-saving customer interfaces, trading and investment strategies, and modelling for risk management, stress testing and compliance. But she said AI poses challenges in terms of "explainability" to customers and even bank employees as to how the technology functions, the potential for a lack of transparency arising from the use of proprietary vendor models, cybersecurity vulnerabilities and susceptibility to fraud from open-source technologies. "The wide availability of AI's building blocks means that phishers and fraudsters have access to best-in-class technologies to build AI tools that are powerful and adaptable," Brainard said, adding that banks will need to develop their own tools to face these threats. "It may be that AI is the best tool to fight AI," she said.
Otting urges foreign banks to choose OCC licensing at national level. Demonstrating an unusually entrepreneurial spirit for a regulator, Comptroller of the Currency Joseph Otting encouraged foreign banks doing business in the US to consider the benefits of operating under a single federal charter, rather than pursuing multiple state licenses. In remarks at a Special Seminar on International Finance in Tokyo on November 14, Otting noted that non-US-based banks seeking to open branches in the US have the option of pursuing licenses in every state in which they have a presence, adding compliance costs and regulatory complexity to their American operations. Or they "could benefit from operating under a single regulatory framework with one prudential regulator – the OCC." While expressing strong support for the dual banking system and acknowledging that banks should choose between the two options based on their own business models and goals, Otting noted that his agency "has a long history of supervising federal branches of foreign banks operating in the country." In particular, he cited "supervisory efficiencies gained by consolidating the supervision of branches of foreign banks with the supervision of the national bank subsidiary, which the OCC already supervises." He also noted that OCC has experts who can provide insights on licensing, legal and supervisory matters to help guide the decision-makers at international firms. Otting used much of his speech to discuss the regulatory reform agenda OCC and other agencies are pursuing, the condition of US banks, which he pronounced "strong," and the risks still facing banks in the areas of credit, operations, compliance and rising interest rates.
Regulators propose streamlined reporting requirements for smaller banks. The Fed, FDIC and OCC have proposed permitting insured depository institutions with less than $5 billion in assets to file the most streamlined version of the call report, the FFIEC 051 Call. In a notice of proposed rulemaking with request for public comment issued on November 7, the agencies said the reduced regulatory reporting burden would apply to those smaller institutions "that do not engage in certain complex or international activities." The current eligibility limit for the simpler call report is $1 billion in assets. In addition, the three agencies are proposing reduced reporting for supervised uninsured firms with less than $5 billion that meet the same criteria. Comments will be accepted for 60 days after the proposal's publication in the Federal Register.
And then there were five: Senate approves Bowman to Fed Board. The Board of Governors got closer to its full complement of seven members with the Senate's confirmation on November 15 of Michelle Bowman to serve as the first person to hold the seat reserved for a community banker, a special designation adopted in 2015. The vote for Bowman, who currently serves as Kansas State Banking Commissioner and previously as president of Farmers & Drovers Bank, was 64-34. President Trump's nomination of Marvin Goodfriend, former monetary policy adviser to the Federal Reserve Bank of Richmond and a professor at Carnegie Mellon University, is still pending before the Senate, despite having been cleared by the Banking Committee in February. The president's nomination of longtime Fed economist Nellie Liang, announced in September, has not yet come before the committee.