WASHINGTON — The Federal Reserve is considering allowing banks a chance to comment on stress tests before they take them and dropping any qualitative review for the largest banks’ performance, according to Randal Quarles, the central bank’s vice chairman for banking supervision.

Quarles is set to testify Tuesday in his first semiannual testimony before the House Financial Services Committee as vice chairman, a role that was created by the Dodd-Frank Act but which went unfilled during the Obama administration.

While the Fed issued a pair of proposals last week to revamp two pillars of the post-crisis regulatory structure, the enhanced Supplemental Leverage Ratio and the Comprehensive Capital Analysis and Review stress tests, Quarles’ testimony suggests the central bank is planning to go still further.

“The U.S. banking agencies' build-out of the regulatory and supervisory framework since the financial crisis has resulted in a substantially more resilient financial system,” Quarles said. “That said … it is inevitable that there will be ways to improve the framework, especially with the benefit of experience and hindsight, and … it is important that we pursue this task as assiduously as we can.”

Randal Quarles
“We are continuing to think about how we can make the stress testing process more transparent without lowering the strength of the test itself or undermining the usefulness of the supervisory stress test,” said Fed Vice Chairman Randal Quarles. Bloomberg News

Following are some of the highlights of his written remarks:

More changes to stress testing

Quarles — like Fed chairman Jerome Powell before him —has said that stress testing is an important post-crisis innovation, but in his testimony favored additional changes that could change the regime significantly.

In January 2017, the Fed issued a final rule that would eliminate the Fed’s practice of issuing qualitative objections to banks with less than $250 billion in assets — effectively reducing the number of banks with qualitative reviews from 33 to 10. Under the Fed’s Stress Capital Buffer proposal from last week, the Fed would also eliminate quantitative objections altogether. And in his testimony, Quarles suggested that the Fed may move to ultimately eliminate the qualitative objections for the largest banks as well.

“I believe that our supervisory goal of ensuring a robust capital planning process at most firms can be achieved using our normal supervisory program combined with targeted horizontal assessments without compromising the safety and soundness of the financial system,” Quarles said.

Quarles also said that he believed that the stress testing process can be made more transparent. Under both CCAR and the Dodd-Frank Act Stress Test, banks’ balance sheets must maintain minimum capital levels even under severely adverse conditions.

Those hypothetical conditions change from year to year, and banks have argued that the nature of those conditions can have major implications for how a bank allocates its capital, and therefore should be subject to a notice-and-comment rulemaking process. In his testimony, Quarles seemed to agree.

“We are continuing to think about how we can make the stress testing process more transparent without lowering the strength of the test itself or undermining the usefulness of the supervisory stress test,” Quarles said. “I personally believe that our stress testing disclosures can go further, and that we should consider additional measures, such as putting our stress scenarios out for comment.”

Calls for LCR relaxation

Quarles praised a bill authored by Senate Banking Committee chairman Mike Crapo, R-Idaho, that he said offer “prudent modifications” to Dodd-Frank. But he said an additional change would be welcome, namely one that would allow the Fed to differentiate between Global Systemically Important Banks, or G-SIBs, and other systemically important banks for the purposes of the Liquidity Coverage Ratio.

“The full liquidity coverage ratio requirement of enhanced prudential standards applies to large, non-G-SIB banks in the same way that they apply to G-SIBs,” Quarles said. “I believe it is time to take concrete steps toward calibrating liquidity requirements differently for non-G-SIBs than for G-SIBs.”

The Treasury Department’s blueprint for tailoring banking rules from last June included the LCR among the rules that it sought to tailor and adjust, including limiting the rule to G-SIBs and applying a less stringent liquidity standard to internationally active banks. The blueprint also suggested that the LCR should be changed in order to expand the types of assets that qualify as High Quality Liquid Assets, though Quarles made no mention of that change in his prepared testimony.

Biannual living wills

Quarles said that the resolution plans, known as “living wills,” required of systemically important financial institutions in Dodd-Frank should also move from an annual to a biannual exercise, as well as reconsider how much and what types of information are required for differently-sized banks.

“I believe that we should adopt a permanent extension of submission cycles from annually to once every two years, and that we can again reduce burden for firms with less significant systemic footprints by reducing specific information requirements,” Quarles said.

The regulators have been dogged for years by the annual living will evaluation process, with banks frequently having to commence the next year’s living will compilation before they have received the results of the previous year’s results. The Fed and Federal Deposit Insurance Corp. in September opted to delay the next living will submission for the eight largest banks until 2019 amid concerns about the time required to examine the documents, which can run into the thousands of pages.

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