Fed could write a new chapter on bank supervision in 2020

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WASHINGTON — Over the past decade, the federal bank regulators have been in a constant state of writing rules.

There were rules immediately responding to the 2008 mortgage debacle, followed by the more gargantuan post-crisis regulations mandated by the 2010 Dodd-Frank Act.

With the end of 2019, the agencies — most notably the Federal Reserve — appear to be coming to the end of yet another rulemaking chapter: a period of policy changes aimed at recalibrating the post-crisis framework.

More adjustments could still be on the horizon in 2020, but Fed officials have given signals of late that their recalibration efforts are largely complete and the central bank's regulatory arm is heading into a new phase focusing on improving the bank examination process.

“You're dealing with a more amorphous issue when you're dealing with exam process. It's how people interact and how they respond to a certain set of criteria,” said Greg Lyons, a partner at Debevoise & Plimpton. “Changing this is something unlike changing regulation, which obviously the Fed has done since its formation. This concept of directing exam process is a bit more new.”

The Fed played a central role following enactment of Dodd-Frank implementing rules that strengthened oversight of big banks. Similarly, the agency has run point on writing rules mandated by the 2018 regulatory relief law, which eased many of those post-crisis provisions.

Perhaps most notably, in 2019 the Fed finished rules tailoring prudential standards for banks between $100 billion and $250 billion of assets. While Dodd-Frank had placed all institutions above $50 billion effectively in the same bucket, the new framework tailored requirements across different categories of size and riskiness.

In 2019, “tailoring was the big story at the Fed,” said Keith Noreika, a partner at Simpson Thacher and former acting comptroller of the currency.

In addition to rule changes the central bank made on its own, the Fed jointly finished rules with the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency easing certain liquidity and capital requirements — in some cases fulfilling requirements of the reg relief law and other cases going beyond their congressional mandate. The agencies notably finalized a new leverage ratio just for community banks, and simplified the Volcker Rule compliance process. The Fed and FDIC also eased living will requirements.

With the overhaul of post-crisis rules as required by the reg relief law now complete, some Fed officials have suggested that refining the agency’s supervisory approach could top the agenda going into the next year.

“The most important thing that the Fed does during this period is to think intentionally then about ... what can we do through supervision, and how do we make that effective but also fair,” said Fed Vice Chair of Supervision Randal Quarles at an event hosted by Georgetown University's law school in September.

Quarles went on to say that supervision can “provide some warning notice” for banks and “opportunity for input” from regulators without the procedural constraints that accompany writing rules.

The Fed took some steps in 2019 to give the banks it supervises more insight into its stress testing regime, which it uses to monitor the safety and soundness of some of the nation’s largest banks. In the 2019 round of the Comprehensive Capital Analysis and Review stress tests, the Fed provided “significantly more information” about the tests, including more detailed descriptions of the models used to evaluate banks.

Quarles has continued to mention in public speeches “an increasing focus on exams and exam-related issues,” said Lyons.

“I think [Quarles] has a concern — probably speaking with some of the banks — that although there are clearly changes happening at the top of the house as far as rulemaking and so forth, if the exam process doesn't also adapt to the different types of institutions, the top of the house isn’t going to matter as much,” Lyons added.

Such comments from officials make “a real-world practical impact on the supervision of institutions on a day-to-day basis,” said Stephanie Brooker, a partner at Gibson Dunn.

“Statements from leaders at the Fed like Vice Chair Quarles about the need for clear and consistent supervisory communications, the statement that guidance should not be the basis for citations of violations of law — [those] do have an impact on field examiners in their approach to examining banks,” she said.

In recent years, banks have raised various issues with the examination process, including cross-institutional or horizontal examinations to compare “peer institutions,” said Noreika. Banks could benefit from more transparency on how institutions are grouped together, he added.

“What we've seen is a concentration on so-called best practices, and the best practices seems to be becoming all-encompassing guidance on how to run your business,” he said. “Some of the manifestations have been somewhat confusing, where different institutions in the same ‘peer group’ who have different business lines and types of customers are being held to the same best practices.”

Brooker hypothesized that banks might see fewer public enforcement actions or consent orders in a climate that emphasizes the supervisory process. Instead, institutions could see more non-public memoranda of understanding or "matters requiring attention" citations.

That would be particularly significant to foreign banks, she said.

“When you have a public enforcement action in the U.S., it has a ripple effect to the parent in whatever country the parent is located, and can also have cultural impact,” said Brooker. “In certain cultures [it can create] more of a sense of shame, or impact on the foreign regulator, so I think these types of regulatory comments in this climate can have a real impact on how they're supervised.”

While changes to the supervision process may be less public than the Fed’s regulatory revisions, there are still several areas where adjustments to supervisory policy may come to light, said Lyons.

“You could see, for example, in some supervision or regulation letters, some directives as to how to approach exams or how to approach the ability of a bank to rebut findings in an exam, because right now currently, the exam process is fairly one-sided in that the examiners come to their conclusions and there really isn't a meaningful opportunity as part of the exam for the bank to push back on some of the findings,” he said.

The Fed could also use a rulemaking to craft guidance for supervisors, said Lyons.

“You also could see it come through in the preamble to regulation,” he said. “You could see them not only talking about the rule itself, but giving guidance in the preamble as to how the rule is to be implemented, and I think that would be useful for the banks as well.”

Supervision may also come into play as the Fed examines what exactly happened that caused the interest rate on overnight repurchase agreements to spike in September. That crunch forced the Fed to inject liquidity into the market to stabilize the rate, but questions remain about what caused the sudden spike and why banks failed to deploy their own liquidity.

In his testimony to the House Financial Services Committee on Dec. 4, Quarles said that liquidity stress tests overseen by examiners could have been one source of the strain.

“I think we need to examine them, particularly among them the internal liquidity stress tests that we run that create a preference, or can create a preference, at some institutions for central bank reserves over other liquid assets including Treasury securities,” he said to lawmakers.

The repo issue, as well as the root cause of it, will also be a key issue going into 2020, said Noreika, who said that the Fed should examine “the effect of prudential regulation on capital markets and the marketplace.”

“You're already seeing this with the Fed having to really intervene in the repo markets,” he said. “There's a reason for that, and the reason is the fenced liquidity rules, because the banks are sitting on tons of liquidity that they can't employ like they normally would in the marketplace.”

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Regulatory reform Regulatory relief Stress tests Regional banks Randal Quarles Federal Reserve