Lackluster governance and control standards would no longer disqualify banks from mergers and acquisitions under a new proposal from the Federal Reserve.
The Federal Reserve Board of Governors voted 5-1 to issue a set of proposed changes to its Large Financial Institution supervisory ratings framework for public comment on Thursday afternoon. The LFI label generally refers to banks with more than $100 billion of assets.
Under the proposal, which passed with five yes votes against one no and one abstention, LFI banks could still be considered well managed even if they are considered deficient in one of the three categories assessed in their supervisory reviews — capital, liquidity, and governance and controls.
In a written statement, Fed Vice Chair for Supervision
Bowman noted that the Fed's latest supervision and regulation report shows more than 60% of LFI holding companies were deemed not well managed despite capital and liquidity levels being well above regulatory minimums. Bowman has highlighted this disparity
"The proposal would generally require a deficiency in either a large bank holding company's capital or liquidity ratings, in addition to a deficiency in its governance and controls, in order to be classified as not well managed," Bowman said in her statement. "In this way, the proposal would provide greater recognition of a firm's overall condition in determining well-managed status. By addressing this mismatch between ratings and overall firm condition, the proposal adopts a pragmatic approach to determining whether a firm is well managed."
In each of the three assessment categories, LFI banks are deemed as either broadly meeting expectations, conditionally meeting expectations or given a score of deficient-1 or deficient-2. Currently, a deficient rating in any single category prohibits a bank from being deemed well managed. Typically, only well-managed banks are allowed to acquire or merge with other banks.
Along with changing the standards for being deemed well managed, the proposal would also remove the requirement that banks receive enforcement actions if they are deemed deficient-1 in any one category. Instead, such decisions would be left up to case-by-case discretion.
"Supervisors will continue to assess firms, identifying weaknesses and areas in need of improvement or remediation," Bowman said. "When firms fail to meet expectations, supervisors will take appropriate actions, which may include issuing supervisory directives (like matters requiring attention), downgrading a firm's component ratings, and in some cases, pursuing formal or informal enforcement actions."
The proposal also calls for similar ratings changes to its Insurance Supervisory Framework, which applies to bank holding companies that are significantly involved in insurance underwriting. That framework is similar to the LFI framework in that it evaluates firms based on capital, liquidity, and governance and controls.
Critics have said the governance and control category offers examiners
Yet, some say the governance and control categories provide distinct insights into how well a bank is run and reveal risks that might not be apparent on its balance sheet or financial disclosures.
Fed Gov. Michael Barr — who served as vice chair for supervision under President Joe Biden before
"These serious deficiencies can cause harm not only to the bank being rated, but also, as we have seen, to the financial system, to consumers, and to our society as a whole," Barr said in a written statement. "Such a firm should not be deemed to be well managed."
Barr added that the changes outlined in the proposal could put the Fed in violation of the Gramm Leach Bliley Act of 1999, which requires bank holding companies to have satisfactory management practices in order to become financial holding companies.
"Today, the governance and controls rating in the LFI framework is supervisors' primary means of evaluating the management of large financial institutions," Barr said. "It would therefore be inconsistent with the definition of the term to treat a firm with a deficient-1 rating in governance and controls as being well managed, as the proposal does."
Fed Govs. Lisa Cook and Adriana Kugler also expressed some concerns about the proposed changes in their own written commentaries.
Kugler, who abstained from voting on the proposal, agreed that it would be a "problematic outcome" if banks were being deemed not well managed based solely on "a discrete deficiency that does not necessarily reflect the overall condition of the firm" — as the proposal describes — but said she worries the proposal would tilt the scales too far in the other direction.
"Specifically, under the proposal, if examiners observe multiple deficiencies that fall within a single component rating the institution could still be considered 'well managed' because the proposal does not include a composite rating to determine whether a bank is well managed," Kugler said. "This would no more reflect a holistic assessment of the firm than the current framework does."
Cook voted in favor of issuing the proposal, expressing concern about the volume of banks deemed not well managed despite high levels of capital and liquidity. She said changes to the LFI framework in 2018 could be to blame, resulting in well-run banks being unduly penalized.
But, Cook also endorsed the idea of incorporating a composite score — a concept that is reflected in one of the questions included in the proposal.
"A composite score would produce a more holistic assessment of the organization — across individual components — and allow more nuance to distinguish well-managed from not well-managed organizations," she said.
Banking groups praised the move, with Bank Policy Institute President and CEO Greg Baer calling the proposal "overdue but welcome" and urged the Fed board to swiftly finalize the rule. BPI represents the largest U.S. banks, many of which would be subject to the rule.
"It never made sense for the grade on any test to be the worst answer to any question, and of course, this approach yielded the outcome of two-thirds of large U.S. banks being rated in unsatisfactory condition," Baer said in a statement. "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."
