Fed Stability Report Incomplete (December 5)

Update 316 — Fed Stability Report: Incomplete
Missing: Systemic Risk and TBTF Analysis

Yesterday, the Dow lost over 800 points, its third worst point decline in history; the S&P 500 saw its steepest fall since February. Waves of selling are hitting Wall Street amid fear of slowing economic growth and trade tensions between the U.S. and China.  The VIX — Wall Street’s fear gauge — is on the rise again and hasn’t fallen below the 15 point benchmark for market stability since September.

Not the picture of financial stability. This of course was not reflected in the Federal Reserve’s Report on Financial Stability yesterday.  But neither was analysis conducted or even reference made to TBTF and systemic risk in the financial sector, oddly. There’s a curious Nothingburger here.  Details below…




Last week, the Federal Reserve released its first Financial Stability Report, a new semi-annual publication that will provide an overview of the health of the financial system.  Missing from this overview is a thorough discussion of regulatory rules and their impact on systemic risk — a curious oversight given that the Fed announced its plans to reduce capital and liquidity standards for banks between $100 and $700 billion in assets just last month.  These changes will increase systemic risk and instability in the financial system. The Fed’s report concludes that big bank capital and liquidity is adequate, but ignores the systemic risk implications of its current rulemaking proposals and market forces, such as debt levels and increasing consolidation in the sector.

The Fed’s First Financial Stability Report

The Fed’s new semi-annual report complements the existing annual report by the Financial Stability Oversight Council (FSOC) and is similar to others produced by central banks around the world. The Fed has lagged behind other countries in terms of transparency, so this report is a welcome step in aligning to global norms. Fed Governor Lael Brainard calls it “an important step in providing the public with more information about the board’s assessment of financial stability.”

The report was generally positive; the labor market is strong, inflation appears to be controlled, and wages are growing moderately. The report did, however, identify four broad categories of vulnerability in the financial system:

  • Elevated valuation pressures: Echoing Brainard’s warning in a speech earlier this year, the Fed is concerned that elevated asset prices are signalling an increased willingness of investors to take on risk. Greater appetite for risk implies a greater possibility of outsize drops in asset prices, or losses, that could shock the financial system. This risk has been made clear by the recent volatility in the U.S. stock market.

  • Excessive borrowing by businesses and households: Historically, heightened borrowing by businesses and households has resulted in major stress on consumers, as well as the financial system. After a steady rise at pace with nominal GDP, business and household borrowing is starting to grow at a faster rate. Business debt levels in particular are high, with signs of increased risky debt issuance and deteriorating credit standards. Although household debt is concentrated among low-credit-risk borrowers, households are still struggling with student, auto, and credit card loans.

  • Excessive leverage within the business sector: The leveraged loans market is worth just over $1 trillion, and in its report, the Fed highlighted this market as another cause for concern. Current regulators have rolled back the leveraged loan safeguards put in place by Obama-era regulators. Investors have flocked to this market, and leveraged loan prices will likely deteriorate rapidly in the event of a crisis. Leveraged loan funds have already seen heavy outflows in recent months.

  • Funding risk: Many firms have taken advantage of the period of record-low interest rates after the financial crisis by taking on mountains of debt. Both the Fed and the Office of the Comptroller of the Currency (OCC) have expressed concern about the high level of corporate debt. Per the report, corporate borrowing levels are “historically high” and debt at US nonfinancial companies is up nearly 70 percent since 2008. Ominously, debt levels at nonfinancial companies have typically risen sharply just before the past three downturns.

If It Ain’t Broke, Don’t Unfix It

The report concluded that “the nation’s largest banks are strongly capitalized” and “hold more liquid assets” than in the period leading up to the crisis, making them more resilient in case of another downturn. Despite the relatively rosy tone taken by the Fed on the state of the financial sector, it continues to plug away with the deregulatory agenda meant to roll back “burdensome” Dodd Frank-era rules.

Last week, the Fed released an official rule report outlining a number of changes that were first presented by Vice Chair Quarles about a month ago. The rule report is a detailed overview of how the Fed plans to implement S. 2155 and “tailor” regulatory processes. These proposed changes include:

  • raising the asset thresholds for banks to be subject to enhanced prudential standards

  • overhauling the Dodd-Frank stress testing framework

These changes are likely to increase systemic risk and harm the stability of the financial system. Find a more detailed explanation of our views on the proposed changes here.

Monetarist Approach to Systemic Risk

When it comes to monetary policy, the Fed is on cruise control. The Board has raised the short term interest rate eight times since 2015, the last time in September from 2 to 2.25 percent, as part of the Fed’s dual-mandate to achieve full employment and sustainable inflation rates. Given those narrow objectives, the Fed has done a commendable job, but is it doing the right things to protect those gains in the future?

While mainstream media seems enamoured with last-minute changes to the interest rate, they fail to see what the Fed is doing when it comes to regulation and oversight, which may have more impact on the economy in the long-run. Vice Chair Quarles is pushing rule changes to capital regimes at a time when risk in the economy is low, but continued growth is uncertain.


The current Fed is on a mission, seeking to reduce capital and regulatory standards at precisely the most counter-cyclical time. Coming to the end of a long period of growth and stability, we need the safeguards implemented by Dodd-Frank. Reducing regulatory requirements at this juncture facilities risk-taking by financial institutions as the economy slows, setting up a repeat of 2008 as institutions chase returns that will be increasingly diminished.

In a speech at the Economic Club of New York on Wednesday, November 28, Powell said: “The question for financial stability is whether elevated business bankruptcies and outsized losses would risk undermining the ability of the financial system to perform its critical functions on behalf of households and businesses.” Powell contended, as his predecessors did in the run-up to 2008, that such losses would likely fall on investors rather than posing a threat to the financial institutions that are at the core of the system.

If history has taught us anything, it is that average Americans are always the ones who bear the brunt of financial crises, not wealthy investors.  During his speech last week, Fed Chair Powell asserted that monetary policy should not be used as a tool for stabilizing a financial crisis, yet he appears content in allowing the Fed to pursue destabilizing rule changes in financial policy.


Fed Undertakes Implementation of S. 2155 (November 16)

Update 313 — Quarles Tailoring Too Swiftly?
Fed Undertakes Implementation of S. 2155

The current Congressional interregnum known as the Lame Duck session affords a chance to consider how the Fed plans to implement S. 2155, the broadest rollback of Dodd-Frank to date.  So far, evidence suggests that the implementation process be watched closely.

It invokes serious issues ranging from the limits of regulatory discretion to systemic risk policy on the merits.  We commend, as a sensible alternative to the proposal Fed Governor Quarles is concocting, the perspective of Governor Lael Brainard.  See below.

Good weekends all,




Yesterday, Michelle “Miki” Bowman was confirmed as Fed Governor by the Senate on a 64 to 34 vote. She adds another deregulation supporter to the Fed Board.

This week, the Fed’s Vice Chairman Randal Quarles testified in front of the House Financial Services and Senate Banking Committees to give an overview of the supervision and regulation of the financial system. His testimonies come after a speech last Friday at Brookings, where he detailed a list of changes to the current stress testing regime. It also comes in the wake of a Fed proposal last month to ease regulation for banks under $700 billion in assets.  

Will Fed Eviscerate Stress Tests?

On November 9, Randal Quarles gave a speech at Brookings detailing plans to overhaul the Dodd-Frank stress testing framework for the largest financial institutions. In the name of efficiency, “recalibration,” and “tailoring,” the Fed is proposing to reduce standards that were designed to ensure the resiliency of banks to weather any crises and are the basis for capital requirements.

The changes under consideration by the Fed are:

  • exempting banks with assets less than $250 billion from CCAR quantitative assessment and supervisory testing in 2019

  • disclosing stress test outcomes to firms before they execute their capital distributions

  • exempting leverage ratio requirements from future stress testing models

  • decreasing capital buffers for most banks by 2020 at the earliest

Capital and Liquidity Rules in Fed’s Sights

Late last month, the Federal Reserve Board voted 3-to-1 to reduce oversight and capital requirements for the 16 largest regional banks in the country. The Fed “tailoring” (deregulating by another name) implementation is now in full force.

The Fed’s proposal would create four new categories for how bank holding and savings and loan companies are treated:

  • Category I: Global Systemically Important Banks (GSIBs)

  • Category II: Banks with more than $700 billion in assets or $75 billion or more in cross-jurisdictional activity

  • Category III: Banks with between $250 billion and $750 billion in assets

  • Category IV: Banks with between $100 and $250 billion in assets

The proposal would be a huge let-off for banks in the $100 to $250 billion asset range, such as BB&T and Suntrust. These banks will be exempted from the liquidity coverage ratio, substantially reducing their requirement to be able to turn assets into cash in the event of a crisis. Fed Governor Lael Brainard estimates that these changes would reduce high quality liquid assets by around $70 billion and reduce their liquidity buffers by around 15 percent.

The changes also reduce oversight by eliminating the annual stress test requirement for these institutions, moving it to a bi-annual basis. Large “mega-regional” banks with assets between $250 and $700 billion such as US Bancorp, Capital One, and PNC Financial would also face much lighter liquidity requirements, equivalent to 70 to 85 percent percent of their current liquidity coverage ratio.

Signed into law in May, S. 2155 was touted as a regulatory relief bill for smaller banks and credit unions ostensibly stifled by excessive regulation, but the Fed’s new rule loosens restriction for mega-regional banks between $250-700 billion in assets. These mega-regionals are as or more likely to be both culprit and victim in a meltdown as any firms in other financial subsectors, given their increasing interconnectedness with each other, as well as with their Wall Street counterparts.

Per Sen. Brown: The “Fed’s proposed rule loosens protections for banks with more than $250 billion in assets – not small community banks – we’re talking about the nation’s biggest financial institutions.”  Ten years after the financial crisis, the nation’s most important regulators are eroding the fundamental protections offered under Dodd-Frank, increasing systemic risk, and leaving taxpayers at risk of a future bailout.

Consternation in Congress

On November 14, Democrats on the House Financial Services Committee (HFSC) raised their concerns with the Fed’s new proposals. Rep. Maloney questioned the provision to reduce the liquidity requirement for banks in the new Category III tier. Quarles argued that the language of S. 2155 now requires the Board to tailor policies to institutions between $100 and $250 billion in assets, but did not fully justify the decision to lower liquidity standards for such large banks. Moreover, the statement was inconsistent with his remarks against supervisory complacency in boom times.

The next day, Quarles recanted this testimony before the Senate Banking Committee. Sen. Brown highlighted his concern over the proposed reduction in capital requirements and argued that the proposed stress test “transparency” measures were akin to giving “students the answers to a quiz ahead of time.” Sen. Warren questioned the reduced enforcement of leverage lending ratio guidelines, forcing Quarles to admit that they would not hold banks to the standards set by the Fed, OCC, and FDIC in 2013.

Tailoring Too Swiftly?

In recent months, the Fed has proposed other significant rule changes, like adjusting the the enhanced supplementary leverage ratio (eSLR) — a change predicted to reduce GSIB capital requirements by $121 billion. The Fed is also on the verge of proposing changes to living wills requirements, releasing banks in the $100 to $250 billion asset range from filing resolution plans, thereby increasing systemic risk.

A Toxic Brew of Deregulation

The Fed is pushing ahead with rulemaking that threatens to increase systemic risk and harm the stability of the financial system. Fed Governor Lael Brainard explains, “I see little benefit to the institutions or the system from the proposed reduction in core resilience that could justify the increased risk to financial stability and the taxpayer.”

This deregulatory agenda will soon have a powerful challenger in Congress. The likely next HFSC Chair, Maxine Waters, told the public during the Nov. 14th hearing: “Make no mistake, come January, the days of this committee weakening regulations and putting our economy once again at risk of another financial crisis will come to an end.”

Fed Developments – How Trump is Shaping Financial Regulations (October 9)

Update 304: Fed Developments – Nominations and Rules;
How Trump is Shaping Financial Regulations

On September 26, far away from the Kavanaugh maw, the Federal Open Market Committee (FOMC) voted to raise the target range for the federal funds rate from 2 to 2.25 percent. The market expects one more rate hike this year, three increases in 2019, and one in 2020. During the press conference after the interest rate announcement last week, Federal Reserve Chair Jerome Powell remarked on the record low unemployment, robust economic growth, low and stable inflation, and modest wage growth as the backdrop to the FOMC decision to raise rates.

While the Fed’s monetary policy updates may be predictable at this juncture, other developments at the Fed, including some notable nominations and concerning rulemaking proposals are detailed below.  




Board Nominations

Republican obstructionism during President Obama’s tenure gave President Trump the opportunity to appoint six of the seven Fed Governor seats, all of whom serve 14-year terms. The administration is targeting the Dodd-Frank framework, so these nominees and their ideological positions are crucial in charting the Fed’s deregulatory agenda. There are three remaining Board seats to be filled with Fed Chair Jerome Powell and Vice Chairmans Randal Quarles and Richard Clarida appointed under the current administration.

  • Richard Clarida

Richard Clarida was sworn in last month as Vice Chairman and member of the Fed Board of Governors after a 69-26 vote in the Senate. During his Senate Banking Committee confirmation hearing, Sens. Warren and Cortez-Masto both expressed concerns about his views on regulation, specifically capital and liquidity requirements. Clarida responded by expressing his support for tailoring — the new euphemism for deregulating — post-crisis banking rules in order to make the financial system more “efficient” without increasing systemic risk.

  • Marvin Goodfriend

Conservative economist Marvin Goodfriend was nominated to the Federal Board of Governors in November 2017 and has had a halting confirmation process. Backed by establishment conservatives but disliked by libertarian-leaning Republicans and Democrats, Goodfriend is an inflation hawk and critic of monetary policy instruments, such as quantitative easing. During his confirmation hearing, Goodfriend was narrowly approved by Senate Banking in a 13-12 party-line vote. Many believe that this nomination will not go forward.

  • Michelle Bowman

In April 2018, former Kansas Bank Commissioner Michelle Bowman was nominated to the Fed and was approved by Senate Banking in June, 18-7, with five Committee Democrats voting in favor. With her background in community banking, a component required by Congress of at least one Board member, Bowman is viewed as a reasonable and responsible, if conservative, choice. The seat has been empty since 2015, when Obama’s nominee, Allan Landon, was blocked by Senate Republicans. The fifth-generation banker will likely be approved by the Senate in the coming months.

  • Nellie Liang

Last month, President Trump nominated former Fed economist, Nellie Liang, to the Fed’s Board. Under former Fed Chair Ben Bernanke, Liang was director of the Office of Financial Stability Policy and Research at the Federal Reserve Board, tasked with identifying weaknesses in the financial system. Liang, a senior fellow at the Brookings Institution since 2017, argued for a preemptive and proactive approach to identifying risk in the financial system in a paper just last week. She would likely bring this view to the Board if confirmed.

Liang’s nomination is curious. Her background in identifying risks in the financial system seems at odds with the ideological views of some of Trump’s other Board picks. Incidentally, Liang is a registered Democrat. There is a history of pairing Fed Board nominations to appoint one member from each party but, so far, Liang’s nomination has not been tied to another candidate. It remains fairly likely that this is the administration’s goal with Liang, so it’s worth watching for additional nominees.

2155 Legislative Intent and Fed Discretion

When Congress passed S. 2155 in May, many members voted to free community banks from prudential standards they considered unnecessary to smaller firms. What some in the GOP wanted, expressed in a letter written by Sen. David Perdue to Quarles on August 17 of this year, was to redefine the entire supervisory regime. They wanted to liberate big banks from the enhanced prudential standards, such as supervisory stress testing, that were enacted to keep too-big-to-fail banks in check.

The stress testing framework in Dodd-Frank was adopted to test the resiliency of financial institutions under hypothetical macroeconomic stress conditions. Even before S. 2155, the Fed had begun proposing rule changes in the name of transparency, which included releasing the modeled loss rates on different groupings of loans and the estimated loss rates on hypothetical portfolios of loans. These changes may encourage firms to tailor their balance sheets to fit in with the stress tests, effectively allowing them to circumvent the supervisory exams entirely.

De Novo Deregulation

The Fed is planning its own de novo rule changes that would loosen regulation on some of the biggest banks. The rules would change how the Fed defines a big bank and what asset sizes require increased regulation. Quarles has called the asset sizes out of date, stating that “it is clear that there is more that can and should be done to align the nature of our regulations with the nature of the firms being regulated.”

The two rule changes, both raising the asset threshold for heightened regulatory oversight to $250 billion and loosening regulations for those that meet it, are focused on:

  • Liquidity Coverage Ratio (LCR): Established by Dodd-Frank after the Great Recession, the LCR rule requires enough cash or easy-to-sell assets to cover one month of liabilities.
  • “Advanced Approaches” Rule: Established before the financial crisis, these rules outline how to calculate a bank’s capital position.

Designation: Sparingly?

During the Q&A portion of Powell’s FOMC press conference last week, Greg Robb of MarketWatch asked about Powell’s confidence in the stability of the financial system given the lack of FSOC oversight of nonbanks. Powell acknowledged the potential risks in the nonbank sector and noted that, “another Lehman Brothers [could] come up out of the ground… which could be capable of creating systemic risk.”

Despite this admission, Powell said that FSOC authority over systemically important nonbank financial firms should be used “sparingly.” Powell’s remarks were disappointingly consistent with the deregulatory agenda of the administration and out of line with the goals of Dodd-Frank — the $50 billion threshold was chosen for a reason and that was not for designation to be used sparingly.

While its monetary policy agenda seems to be on track, the Fed is quietly pursuing a “tailoring” agenda, helping big banks shed some of the regulatory burden of Dodd-Frank.  Whether or not these changes will precipitate another crisis is yet to be seen, but the Fed should fully consider their implications on systemic risk and financial stability.

Much Ado About the Fed (June 15)

Update 279: Much Ado About the Fed
From Systemic Risks To Interest Rates

The Federal Reserve made news this week in the usual way, with another interest rate hike, and also in less visible but important ways.

Today, the Financial Stability Oversight Council (FSOC) — of which the Fed is a key member — met in executive session. Prudential Financial’s status as a non-bank Systemically Important Financial Institution (SIFI) is again on the agenda of the Council, created by Dodd-Frank to monitor systemic risk. Worth watching.

Good weekends all…



SIFI Delisting in the Offing?

Prudential is the one remaining non-bank institution with SIFI-designation status. After deferring on a decision on Prudential’s SIFI status at a meeting in February, the FSOC could hand down a decision on the company’s status today. Previously de-designated non-bank SIFI’s include:

  • AIG (de-designated by Trump’s FSOC)
  • General Electric,(ditto)
  • Metlife, (de-designated via the courts)

Prudential is the last shadow bank to still face enhanced regulatory standards under the Dodd-Frank Act. Prudential’s de-listing would end oversight over all firms in this sector — particularly troubling given that the shadow banking sector makes up the fastest growing portion of the American financial system, another signal from the administration that safety and soundness take a backseat to systemic deregulation.

Monetary Policy

As expected, the Fed raised interest rates 25 basis points from 1.75 percent to 2 percent during its eight times a year Federal Open Market Committee (FOMC) meeting on Wednesday. Due to upward revisions in GDP growth projections, the Fed signaled it will raise interest rates two more times this year, increasing the total number of anticipated hikes to four.

In his post-meeting statement, Fed Chair Jay Powell emphasized the gradual nature of any further rate increases and intimated that the Fed remains committed to the wind-down of its balance sheet. He indicated he expects the Tax Cuts and Jobs Act will provide a fiscal policy boost to the economy in the short term, predicting a positive demand side impact over the next three years. He also expects the tax cuts to have noticeable supply side effects, i.e., increased business investment.

With official unemployment at 3.8 percent, its lowest point in two decades, and 191,000 new jobs on average over the past 12 months, the economy is regarded as at or near full employment. Somewhat paradoxically, a Bureau of Labor Statistics report released earlier this week found that hourly wages actually fell between May 2017 and May 2018. Powell stated that the Fed is “puzzled” by the lack of wage growth, but responded to questions by asserting that the low unemployment rate should see wages tick up in the near future.

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Fed Rules and Regulatory Policy

Within the next few weeks, Federal Reserve will finalize proposals to change two pillars of Dodd-Frank systemic risk policy: the enhanced supplementary leverage ratio (ESLR) and stress testing. A third change addresses interfirm credit exposure risk. The changes alter the framework that is in place to ensure systemically important banks maintain sufficient loss-absorbing capital buffers to withstand crisis conditions.

  • ESLR – This capital requirement currently applies to the eight most systemically important banks in the country. The new proposal cuts back minimum leverage rules for each of these banks, replacing the fixed 2 percent capital buffer with a buffer equal to one half the firm’s Globally Systemically Important Bank (GSIB) surcharge. The public comment period closes June 25 but it will likely be months before it is finalized.
  • Stress Testing – Under the proposal, severely adverse stress test results would impact a bank’s required stress capital buffer. This change would work to integrate stress testing with the regulatory capital regime, but the proposal also waters down some stress testing assumptions. Based on the latest data, the proposal would cut aggregate capital at banks subject to stress testing by $30 billion. As with the ESLR rule, the comment period closes June 25th but it will likely be months before it is ultimately finalized.
  • Credit Exposure – On Thursday, the Fed approved a rule to prevent concentrations of risk between the nation’s largest banks. Under the rule, banks considered Globally Systemically Important Banks (GSIBs) are given an exposure limit of 15 percent of Tier 1 capital when lending to any other GSIB. Banks holding $250 billion or more in total consolidated capital are limited to a 25 percent Tier 1 capital limit to any counterparty, a threshold that was increased from $50 billion in assets following the passage of S. 2155.

Pending Nominations

On Tuesday, the Senate Banking Committee advanced the latest Trump picks for top roles at the Fed. The committee voted 20-5 to recommend Richard Clarida for Vice Chairman, and 18-7 in favor of Michelle Bowman to be a Fed governor as a community banker on the Board.

During a Senate Banking Committee hearing on May 15, Clarida hued close to the Powell line as he described his views on normalizing monetary policy. He also agreed with Powell on the Fed’s regulatory mandate, arguing that “there are opportunities to tailor regulations appropriately.”

Michelle Bowman also criticized regulation broadly in her May 15 testimony at the same hearing. Her comments on the “burdensome” post-crisis regulatory framework fits nicely into the narrative of Dodd-Frank rollback and adds another deregulation supporter to the Fed board.

Senate Banking Committee ranking member Sherrod Brown urged caution, noting similarities between the statements of nominees and those of Fed staffers. Despite this, as with Dodd-Frank bill S.2155, some moderate Democrats supported their nominations, a decision that risks more front-page excoriation and embarrassment.

Powell’s P

Powell painted a rosy picture of the US economy during his Wednesday press conference, but there are storm clouds on the horizon. Despite labor shortages, the Fed remains confounded by the lack of wage growth in the economy. As the job market continues to heat up without much sign of wage growth, it is becoming increasingly evident the broken (or flattened) Phillips Curve will be around for at least a little longer.

As the Fed inches toward a natural rate of interest and the post-crisis stimulus continues to wind down, Fed policymakers need to be transparent in their decision-making and swift to react as the economic situation changes. They will also continue to confront a lagging or stagnant wage market that vexes and befuddles labor economists across the country.

Dereg Now, Dereg Whenever (Apr. 25)

Update 266 – Dereg Now, Dereg Whenever:
Capital Rules Debate Pits Quarles vs. Quarrels

If rapidly increasing economic growth, historic highs in financial industry profits, and capital markets in record territory of late all call for deregulation, there’s no bad time for it.  And if proponents of financial deregulation control the House, Senate, and White House — for now — this is most certainly the time, regardless of sectoral circumstances.

Here’s the story of the GOP working with financial regulators and market participants to bring down the “hairpin turn ahead” sign because no more accidents were occurring.




Last Week, Federal Reserve Vice-Chair for Supervision Randal Quarles appeared before House and Senate Committees to answer questions on his approach to supervisory standards.  In recent weeks, the Fed has issued revisions to a number of fundamental post-crisis standards. Quarles’ innocuous words like “efficiency” and “recalibration” belie the serious systemic implications these rulemakings have.  Leading regulators at the Fed and other regulatory bodies have raised important objections.

This while a Senate Banking bill, S.2155, sits at the doorstep of the House.  The Economic Growth Regulatory Relief and Consumer Protection Act would empower the Fed to free 25 of the largest 34 banks from stress testing, living wills, and the liquidity coverage ratio.  Quarles’ rulemakings suggest he is eager to tailor the same DFA pillars that S.2155 would deregulate.

These efforts look like a solution in search of a problem. The banking sector has been unprecedentedly profitable for three years running, lending remains strong, and the economy as a whole is gaining steam.

GOP Regulatory Pref: Capital over Supervisory

Reduced capital levels run counter to what some Republican appointees and officials have suggested about the value of capital requirements. In 2016, then-Chair of the Senate Banking Committee Richard Shelby said that for years, he has “urged regulators to implement strong capital standards.”  Just a year ago, Jerome Powell suggested capital levels were just right. Now in power, conservatives seem determined to relax rules for the largest banks under the guise of “modernization,” a familiar deregulatory term.

Capital Regimes Pre- and Post-Crisis

Capital held by the five largest banks doubled from 2008 to 2015, but only from 3 percent to 6 percent. Today, equity capital requirements range from 7 percent to 11 percent of risk-weighted assets, but it appears Quarles is primed to permit a reduction in capital levels.

Proposed Revisions

Enhanced Supplementary Leverage Ratio (ESLR) – On April 11, the Federal Reserve and the Office of the Comptroller of the Currency (OCC) issued a proposal to reduce the enhanced supplementary leverage ratio capital rules applied to Globally Systemically Important Banks (G-SIBs) and their subsidiaries. The proposal’s impact varies from bank to bank, but would slash some ESLR by up to 40 percent. Currently, G-SIBs must maintain a minimum SLR of more than 5 percent (3 percent plus a 2 percent buffer). G-SIB subsidiaries must maintain a 6 percent SLR. The new proposal would take the 2 percent buffer and turn it into a figure equal to one half of the firm’s GSIB surcharge. Subsidiaries’ SLRs would fall from 6 percent after similar tailoring.

•  The FDIC estimates this will result in the GSIB subsidiaries holding $121 billion less in capital at their FDIC-insured subsidiaries. Quarles sought to temper critics who cite this figure by predicting that aggregate capital will fall by just $400 million among bank holding companies. Nevertheless, the discrepancy here is troubling, indicating the Vice-Chair does not see systemic risk residing in subsidiaries across these firms’ operations. In the past, it was the norm for the regulatory bodies like the Fed and FDIC to be on the same page when it comes to capital requirements.

Stress Testing/Capital Buffers – On April 10, the Federal Reserve proposed a new “stress capital buffer” that totals the amount equal to losses incurred during a hypothetical stress test or 2.5 percent, whichever is greater. The revision would replace the existing requirement that 2.5 percent of risk-weighted assets be held as capital. It also replaces the quantitative objection to a firm’s capital plans under CCAR.  Under the new proposal, if a bank has common equity tier 1 capital of 8 percent and it falls to 5 percent, the bank’s stress capital buffer would be 3 percent. This would be added to the minimum 4.5 percent common equity requirement to total 7.5 percent. Federal Reserve estimates suggest this will lead to increased capital among GSIBs, but lower levels of capital among non-GSIBs.

Some analysts are concerned, however, that the loosening of assumptions related to balance sheet growth and the time horizon for expected dividend payments, would ultimately reduce overall capital levels. Recent stress testing data projects these proposals would lower capital at major banks by $30 billion. Goldman Sachs expects the eight largest banks to reduce equity capital by $54 billion as a result of potential stress test changes.

New accounting standard for loan losses – Federal reserve rules include a new accounting standard for loan losses.  This is significant, as it requires banks to forecast and set aside money for easily foreseeable loan losses before they occur. In the lead up to the financial crisis, banks were not recognizing losses well. Since capital rules are in place to guard against unforeseen losses, combining loan loss projections (for anticipated losses) with capital requirements is potentially dangerous.


Source: Federal Reserve Bank of Atlanta; Federal Financial Institutions Examination Council; Journal of Economic Perspectives; Keefe, Bruyette & Woods; regulatory filings


Brainerd on Cyclicality – In the first dissent since the Federal Reserve began to publicly disclose votes, Governor Lael Brainard voted in opposition to a rule that slashes the enhanced supplementary leverage ratio. In a recent speech, Brainerd said it was too soon to consider lowering capital requirements for big banks and urged against making judgements about the current capital and liquidity coverage before a full economic cycle has been completed.

•  Gruenberg on ESLR – FDIC Chair Martin Gruenberg reaffirmed support for the SLR set in 2014, refusing to join the Fed and OCC in issuing the new proposed rule. Gruenberg said leverage ratio requirements are “among the most important post-crisis reforms,” and that “the existing simple approach has served well in addressing the excessive leverage that helped deepen the crisis.”

•  Sen. Warren – At last week’s Senate Banking Committee hearing, Sen. Warren reminded Vice Chair Quarles that taxpayers were left holding the bag when the big banks didn’t hold enough capital. Under the new rule, JP Morgan, Citigroup, and Morgan Stanley could reduce capital by more than 20 percent at their bank subsidiaries and still meet leverage capital requirements. Wells Fargo and Bank of America can each reduce their capital by more than 15 percent.

•  Wall Street Journal – Even the Wall Street Journal’s editorial board criticized the Fed’s proposed supplementary leverage ratio reduction. The board pointed out that the current 6.6 percent leverage ratio among GSIBs is only slightly greater than their losses during the stock market crash in 2008. Reducing them any further would only endanger the system, the editorial board argued.

S. 2155 in this Context

These proposals reflect Quarles’ apparent objective, to include risk-profiling in the financial regulatory capital regime.  Increased tailoring of enhanced prudential standards has been a primary post-crisis goal of congressional Republicans. Critics see tailoring as little more than a euphemism for sotto voce deregulation.

When a handful of Senate Democrats joined with Republicans to pass S. 2155, they voted to give the Federal Reserve a wide purview to tailor enhanced prudential standards on a variety of fronts for banks between $100 and $250 billion in assets.  These pillar revisions include changing the approach to company run stress tests, living wills, and liquidity requirements.

Faced with congressional questioning about how he would customize supervisory standards, Quarles highlighted four key risk profiles for supervisory standards on an individual bank– size, complexity, interconnectedness, and character of bank portfolios. In a rare case of a GOP-led Senate bill ceding authority to the Fed, S. 2155 gives the Fed sweeping discretion to tailor systemic risk rules set by DFA.

What’s Next?  Rules on Fed’s Radar

In his testimony, Quarles hinted more deregulation is on the way at the Fed.  Before the HFSC, Quarles attacked the Volcker Rule, implied he would reduce the risk-based capital surcharge at some of the nation’s largest banks, and hinted that he wanted to end limits on capital distributions due to weakness in risk management at large banks. In front of the Senate, Quarles outlined his plans improve the “regulatory efficiency” of stress testing, calibrate the LCR for non-GSIBS, and enhance stress testing transparency.

While Quarles is powering ahead, S. 2155 is currently held up in the legislative progress. The bill passed a Senate floor vote more than a month ago, 67-31, but has since been held up in the House. This is because Rep. Jeb Hensarling, the outgoing Chairman of the House Financial Services Committee, is refusing to rubber stamp the legislation. For the moment, he has the backing of House Republican leadership. Negotiating with Hensarling would surely involve making the bill more deregulatory, and that would risk alienating cosponsoring Democrats and dissolving the bill’s bipartisan backing.


Through a Glass Darkly (Mar. 30)

Update 259 — Through a Glass Darkly:
The Fed Today, Governance and Structure

With the lull afforded by recess, spring breaks, and holidays, we can take a look at the nation’s central bank, the economy’s most important single institution but one not well understood in terms of governance and structure.

The Fed is in the midst of a transformation, with nominations pending that suggest a policy direction forward. Still, we can only see through this glass darkly. To shed light on the Fed and its governance and structural issues and policy implications, we drill down on the issues and nominations at play.

Good weekends and holidays all,


News at the New York Fed

This month, New York Fed Board recommended San Francisco Fed President John Williams to serve as New York Fed President upon incumbent William Dudley’s departure this summer. His vacancy will be filled by the Fed’s Board of Governors; it is not subject to Senate confirmation.

Williams succeeded Janet Yellen as San Francisco Fed President in 2011 after having served as Yellen’s Research Director at the San Francisco Fed. Williams is seen as promising policy continuation, given a record of supporting the prevailing Fed policy of gradual increasing rates and balance sheet normalization.

He has drawn criticism from Senator Elizabeth Warren, among others, for having supervisory  responsibility for Wells Fargo during the firm’s recent widespread fraudulent account scandal.

The Fed’s Leadership Structure

Williams’ nomination to head the New York Fed potentially bears significance for a Federal Reserve governance structure that is currently under strain from a number of key vacancies.

To illustrate the role of the New York Fed’s place in the Federal Reserve System, we offer this chart depicting the Fed’s (notoriously complicated) governance structure:


Source: https://www.federalreserve.gov/aboutthefed/structure-federal-reserve-system.htm

Board of Governors and Federal Reserve Banks

The Federal Reserve System’s governing body — made up of seven members who are appointed by the President and confirmed by the Senate, with 14-year terms — is led by the Chair (as of this month, Jay Powell) and two Vice Chairs of the Board, also appointed by the President, who can serve up to two four-year terms.

The Board of Governors primarily oversees the operation of the Fed’s 12 Regional Reserve Banks and shares financial oversight and regulatory oversight responsibilities. It also advises Reserve Bank lending to depository institutions and is the primary body in charge of large bank supervision.

At present, the Board of Governors is precariously understaffed with four of seven positions vacant, including a Vice Chairmanship. Observes expect Richard Clarida of Pacific Investment Management to be the next nominee for Vice Chair, likely welcome news for the three sitting overworked Board members.

There are 12 Federal Reserve Districts (Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, San Francisco, and St. Louis). They also implement safety and soundness standards on banks, although responsibility for supervising the nation’s largest institutions has largely moved to D.C.

Federal Open Market Committee (FOMC)

At the heart of Fed monetary policy making is the FOMC, made up of 12 voting members: the seven (or currently three) members of the Board of Governors, the President of the New York Federal Reserve Bank, and a rotating contingent of four of the remaining 11 Reserve Bank presidents.  By tradition, the Chair of the Board of Governors serves as the chair of the FOMC and the president of the New York Fed serves as FOMC vice chair.

Charged with the oversight of “open market operations,” the primary tool through which the Fed directs monetary policy, the FMOC has a hand in all open market operations, affecting the federal funds rate (the interest rate that depository institutions lends to each other at), the size and composition of the Fed’s asset holdings, and regularly communicates with the public about future changes to monetary policy.

NY Fed and the Regulation of Wall Street

The New York Fed President occupies a prominent place in the Federal Reserve system, serving as Vice Chair on the Federal Open Market Committee with voting rights at each meeting (regional federal reserve bank presidents get voting power every three years).

The New York Fed is one of the most important executors of Board of Governor policies. Over the next few years, the NY Fed will give advice and make decisions as to how to wind down the Federal Reserve’s $4.4 trillion balance sheet to normalize holdings to around $2.4 trillion by 2022.

The New York Fed also has a limited role supervising Wall Street firms subject to the Dodd-Frank Act’s enhanced prudential standards.  If S.2155, the Economic Growth, Regulatory Relief, and Consumer Protection Act becomes law, Williams would likely play an advisory role in the tailoring of standards for multiple Wall Street firms with trillions in assets.

Vacancies on the Board Today

Of the seven Governor positions on the Fed Board, at the moment just three are occupied: Chair Jerome Powell, Vice Chair for Supervision Randal Quarles, and Governor Lael Brainard.

This leaves four vacancies to be filled, including the remaining Vice Chair position. Reports indicate John Williams was interviewed for the Vice Chair role before it became clear he is likely to be selected as the next NY Fed President.

Such a vacancy rate on the Board is an historical anomaly, and it creates problems. The Sunshine Act dictates that any meeting of Fed Governors that has a quorum requires public disclosure. Membership of three means any meeting — even an incidental one — between any two of Powell, Quarles, or Brainard might trigger public disclosure requirements.

Ahead: A Trump-Appointed Fed Majority?

After appointing Randal Quarles and promoting Jerome Powell, just two more appointments and confirmations would give President Trump a majority of Governorships on the Reserve Board. He has already nominated Marvin Goodfriend, whose nomination is in trouble. Goodfriend did not win the support of a single Democrat on the Senate Banking Committee after he had difficulty defending a prediction of years ago that lowering interest rates would dramatically increase inflation.

Not certain is when President Trump might appoint nominees to fill remaining vacancies on the Board, but it is evident he has the opportunity to remake the Board’s composition and its policies for years to come. The overhaul would represent the Fed Board’s biggest overhaul since the 1930s.

Trump’s Financial Regulators: One Year in and Changing the Game Already (Feb. 28)

Update 252 — Trump’s Financial Regulators: One Year in and Changing the Game Already

From consumer protection to regulation of firms, the financial regulatory landscape has changed markedly in some areas and is stillborn in others. Trump regulators have made a variety of decisions that has escaped broader notice.

We take a tour of the financial agencies and review major policy and rule making decisions as well as the resulting overall impact of the Trump administration on the financial regulatory world, providing some context for the debate coming up on S. 2155, the Economic Growth, Regulatory Relief, and Consumer Protection Act, now slated for Senate floor action next week.



FSOC Shedding Designations

During the Obama years, Financial Stability Oversight Council (FSOC) designated four companies as systemically important non-financial institutions in addition to the large banks that are statutorily designated. These included American International Group (AIG), General Electric Capital Corporation (GE Capital), Prudential Financial, Inc., and MetLife, Inc. These designations were short lived. GE Capital was delisted in June, 2016 after it was spun off from its parent company and deemed no longer interconnected enough to warrant SIFI regulation.

Since President Trump has assumed office, FSOC has moved assertively to delist the insurance companies that were at the heart of the 2008 financial Crisis.

Last September, the Council delisted AIG from its list of systemically important non-financial institutions. While the move won the vote of Janet Yellen, many commenters raised concern for the deregulation of a company that was at the heart of the financial crisis. MetLife challenged it’s SIFI status in court, and had its designation rescinded by District Court Judge Rosemary Collyer in March of 2016. Last month, MetLife and FSOC filed a joint motion to dismiss the federal government’s appeal of that decision.

All indications are that Prudential, the last nonfinancial SIFI, may soon find regulatory relief as well. Last week, FSOC made good on its promise to reexamine Prudential’s designation status. While a final decision on the matter is not expected until later in 2018, the company is lobby hard that its designation is unwarranted. Given the deregulatory zeal of Trump’s FSOC, don’t be surprised to see the nonbank SIFI list at zero before the year is out.



Fed Makes Regulatory Accommodations

  • Living Will Deadline Extension

At the end of September, the Fed issued an accommodating rule on living will submissions, allowing eight of the biggest banks to wait until July, 2019 to submit remediated living will plans to fix weaknesses in earlier submissions. Resolution planning is a key Dodd-Frank Act systemic protection, requiring the largest banks to plan their own failure so the financial system does not plunge into crisis if one banks fails. The groups of banks that benefit from the ruling include the nation’s largest: Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs Group, JP Morgan Chase, Morgan Stanley, State Street Corporation, and Wells Fargo.

  • CCAR Transparency

The word “transparency” has been used frequently in conversations about new approaches to financial regulation. Fed Chair Jay Powell has repeatedly floated the concept as imperative in his reevaluation systemic risk rules. In December, the Fed solicited public comment on its proposals to increase transparency of its CCAR stress testing. These proposals include disclosing the Fed’s modeled range of loss rates for loans held by banks subject to CCAR, portfolios of loans used under stress testing scenarios, and an in-depth description of the Fed’s models, including equations used and variables that influence the outcome of the models.

Just this month, the Fed moved forward to release its scenarios for both CCAR and DFAST stress testing. This year the severely adverse scenario, the most stressful condition tested, will simulate a global recession during which the unemployment rate increases from 4 percent to 10 percent and interest rates on treasuries increase substantially. Now that the banks subject to CCAR have these conditions, they can prepare their balance sheet for the test.

  • Fed Restricts Wells Fargo

In a surprise move, the Fed at the beginning of February that Wells Fargo not be permitted to grow beyond its asset size at the conclusion of 2017. This after a lengthy public revelation about consumer abuses and compliance failures. Most notably, the nearly $2 trillion bank created more than 1.5 million fake checking and savings accounts, as well as 500,000 credit cards that were unauthorized. The edict was Chair Yellen’s final act.



Leadership Change at the OCC and FDIC

  • Undoing Obama Era Safeguards

Trump has filled key financial industry regulators positions at a glacial pace since assuming office. It wasn’t until November 27th that Joseph Otting was sworn in as Comptroller at the OCC. However, the agency has since taking up the charge against the Volcker rule on Wall Street’s behalf. The OCC has also begun the process of weakening its enforcement of the Community Reinvestment Act and softening its position against leveraged lending.

Trump’s appointee to run the FDIC, Jelena McWilliams, was cleared by the Senate Banking Committee with only Elizabeth Warren expressing concerns over the former Fifth Third Bank executive taking charge of the agency. McWilliams has spent time on the Hill as chief council for the same committee that approved her nomination, and at the Fed. While she has been guarded about her regulatory views she has expressed interest in relieving regulatory burden from “community banks” and will play a significant role in the rumored rewrite of the Volcker Rule.

The news has not been all bad at the OCC. Just last month, the bureau levied a $70 million fine on Citibank for failure to adhere to a 2012 directive regarding money laundering. On top of that, the most recent round of indictments from Mueller’s team should draw the attention of the OCC to “Lender B”, which appears to have ventured beyond the law in it’s issuance of loans to Paul Manafort.



The SEC: 180 Degree Turn

Securities and Exchange Commission (SEC) Chair Jay Clayton has pursued fewer penalties under the Trump Administration.  Chair Clayton has expressed that the penalties hurt shareholders and not just the individuals who have been responsible for wrongdoing.

Under Chair Clayton, the SEC has done what Michael Piwowar, a Republican appointee, calls “a full 180” in regulatory enforcement. Between the Obama and Trump Administrations there has been a stark contrast in enforcement. From January to September 2016, the Obama administration issued several regulatory punishments worth $702 million, where the Trump administration only issued around $100 million in punishments from January to September 2017.



CFTC Pullback from DFA Enforcement

Like the SEC under Chair Jay Clayton, the Commodities and Futures Trade Commission (CFTC) under Chair J. Chris Giancarlo has pursued a broad agenda aimed at deregulation and fewer enforcement actions in the derivatives markets.

  • Pullback from Dodd-Frank

Giancarlo’s plan to roll-back Dodd-Frank regulations entitled “Reg Reform 2.0,” features the intent to roll-back Title VII protections. At a Senate Agriculture Committee hearing earlier in February, Sen. Tina Smith (D-MN) questioned Chair Giancarlo about this roll back could increase the risk of a financial crisis. Giancarlo replied that while Title VII is being implemented by the CFTC, many of the reforms are not working and that the Commissioners will look at every section to either strike or significantly reduce regulations.

  • Decline of Enforcement Actions

Chair Giancarlo has also taken far fewer enforcement actions than his predecessors. Sen. Sherrod Brown called the inaction “a deliberate pullback in enforcement.” During the fiscal year that ended in September, 2017, enforcement actions totaled 49, down from 68 the previous year, and the total fines issued were just $413 million, down from $1.29 billion the previous year.

Enforcement actions may, however, be on a rebound. The CFTC announced yesterday that it is expected to file “more than 10” fraud and market-manipulation cases in the coming weeks. Perhaps Chair Giancarlo, a former Obama appointee, understands the importance of enforcement after all.



CFPB: Hostile Takeover

An obsession of conservatives since its inception, the Consumer Financial Protection Bureau (CFPB) has been under steady assault since Trump assumed office. While last month’s legal challenge to the agencies legitimacy fell short in D.C. Court of Appeals (read more in Update 247), managing director Mick Mulvaney has been doing his best to undermine the agency from the inside. Upon assuming office, Mulvaney issued a letter to regulators explaining that he would refuse to “push the line” in order to protect consumers. Three months into his tenure it appears that this means doing everything in his power to make the CFPB dysfunctional.

In December, Mulvaney directed the bureau to freeze the collection of any personally identifiable information from companies it supervises. The move ostensibly about addressing cybersecurity concerns, but Sen. Warren, one of the CFPB’s most vocal defenders, argued the freeze was more about sabotage than substance. Ending the collection of personally identifiable information could potentially slow fraud investigations and cripple the CFPB’s enforcement functions.

All indications are that Mulvaney does not plan on stopping with data freezes. Last month, he issued a Request for Information about the Bureau’s Civil Investigative Demands in order to collect suggestions on how to “improve outcomes for both consumers and covered entities.”  Given Mulvaney’s tenure thus far this strongly suggests an even greater deregulatory push to come at the CFPB.  Expect similar rollbacks at the other regulatory bodies as Trump appointees slowly but surely take over and enact the administration’s agenda at the Fed, OCC, FDIC, SEC, and CFTC.