While discussions about the Federal Reserve these days inevitably focus on the cliffhanger of whether or not it will raise interest rates—a bizarre dilemma that has some on Wall Street actually hoping for bad financial news with hopes it will stay the Fed’s hand—Chairman Jane Yellen went before the House Financial Services Committee late last month to update it on the somewhat overlooked story of its regulatory efforts.

At the hearing, a semi-annual update on the Federal Reserve’s activities, Concerns were raised about recent rulemaking, the effectiveness of its approach to bank regulation, and its independence from Congressional oversight.

“You want to have this super-duper regulatory role where its Fed über alles, but you are not willing to subject yourselves to what the other regulators go through,” complained Rep. Bill Huizenga (D-Mich.), referencing the Federal Reserve’s lack of Congressional budgetary oversight.

Huizenga took the opportunity to make a pitch for two Republican-sponsored legislative packages, the Financial CHOICE Act and the Fed Oversight Reform and Modernization (FORM) Act. The latter bill, first filed in 2015, would, among other things, require the Federal Reserve to conduct cost-benefit analysis when it adopts new rules, impose transparency about bank stress tests, and require Fed employees “to abide by the same ethical requirements as other federal financial regulators.”

The Financial CHOICE Act is a recently announced legislative agenda “to replace the Dodd-Frank Act. Among other things, it would provide an “off-ramp” from the post-Dodd-Frank supervisory regime and Basel III capital and liquidity standards for banks that choose to maintain high levels of capital. It would also retroactively repeal the authority of the Financial Stability Oversight Council to designate firms as systematically important financial institutions and repeal sections and titles of Dodd-Frank, including the Volcker Rule, that limit capital formation.

“We are trying to bring some separation to your function as monetary policy makers as well as your regulatory and supervisory roles,” Huizenga said, adding that, in its early draft, the Dodd-Frank Act would have advanced the notion that the Fed’s regulatory and monetary policy roles should be separated, with rulemaking activities falling under a Congressionally approved budget.

Rep. Jeb Hensarling (R-Texas), the committee chairman, elaborated on how banks, under the CHOICE Act, will reduce their regulatory burden through “a market-based, equity-financed Dodd-Frank off-ramp.” Under the plan, banks that maintain a leverage ratio of at least 10 percent and meet other requirements may elect to be functionally exempt from the post-Dodd-Frank supervisory regime and Basel III capital and liquidity standards.

During the hearing with Yellen, Hensarling complained that the Federal Reserve, post-Dodd-Frank, has “unbridled” authority and has grown “particularly controversial and problematic.” The “secrecy” surrounding bank stress tests, he said, “makes it almost impossible to measure the effectiveness of its regulatory oversight or the integrity of the test findings” Meanwhile, “big banks keep getting bigger and small banks are suffering disproportionately.”

Yellen, of course, had a more positive view of the Fed’s regulatory efforts and whether they have been successful. She did concede, however, that adjustments would be made and moves are afoot to reduce the regulatory burden on smaller financial institutions, notably community banks.

“As we saw in 2008, the failure of systemically important financial institutions can destabilize the financial system and undermine the real economy,” she said. “The largest, most complicated firms must therefore be subject to prudential standards that are more stringent than the standards that apply to other firms. Small and medium-sized banking organizations—whose failure would generally pose much less risk to the system—should be subject to standards that are materially less stringent … We must build on the steps we have already taken to ensure that they do not face undue regulatory burdens.”

One might think that after more than six years of the Dodd-Frank Act, the Fed’s rulemaking activities might be slowing down a bit. That is not the case. “We must continue to monitor for the emergence of new risks, since another key lesson from the crisis is that financial stability threats change over time,” Yellen said.

Recent regulatory efforts by the Federal Reserve include a proposed rule intended to strengthen existing requirements and limitations on the physical commodity activities of financial holding companies. It would require firms to hold additional capital “in connection with activities involving commodities for which existing laws would impose liability if the commodity were released into the environment.” It would also tighten the quantitative limit on the amount of physical commodity trading activity that firms may conduct, rescind authorizations that allow firms to engage in physical commodity activities involving power plants, remove copper from the list of precious metals that all bank holding companies are permitted to own and store, and establish new public reporting requirements on the nature and extent of firms’ physical commodity holdings and activities.

Another recent rule in the works would “prescribe regulations or guidelines that prohibit any types of incentive-based payment arrangements, or any feature of any such arrangements, that [they] determine encourages inappropriate risks by covered financial institutions.”

“You want to have this super-duper regulatory role where its Fed über alles, but you are not willing to subject yourselves to what the other regulators go through.”
Rep. Bill Huizenga (D-Mich.),

The introduction of capital stress testing for large banks “has been one of our signature innovations since the financial crisis,” Yellen said. “As events during the financial crisis demonstrated, capital buffers that seem adequate in a benign environment may turn out to be far less than adequate during periods of stress.” Each year, the Federal Reserve conducts supervisory stress tests each year on banking organizations with $50 billion or more in total assets to determine whether they have sufficient capital to continue operations throughout periods of economic stress and market turbulence.

Yellen revealed that the Federal Reserve is considering changes to the stress test assumptions used in the Comprehensive Capital Analysis and Review process, including the prospect that banks with less than $250 billion, if they don’t engage in significant non-bank or international activity, would be exempt from the “qualitative” analysis of the annual stress tests.

Also, under the current CCAR program, a firm’s capital adequacy is assessed by assuming that it continues to make its baseline capital distributions over the stress test’s two-year planning horizon. “We are considering changing this conservative assumption, in significant part because of the advent of the capital conservation buffer in the regulatory capital rules, which limits the ability of a firm to make capital distributions when its capital ratios are lower than the buffer requirement,” Yellen said. “We are proposing that firms simply add one year of planned dividends to their stress capital buffer requirement in recognition of the fact that firms generally are more reluctant to reduce dividends than share buybacks.”

Congress may also want to consider carving out community banks from two sets of Dodd-Frank Act requirements, including the Volcker rule and incentive compensation limits, Yellen said.

“The risks addressed by these statutory provisions are far more significant at larger institutions than they are at community banks,” she explained. “In the event that a community bank engages in practices in either of these areas that raise heightened concerns, we would be able to address these concerns as part of the normal safety-and-soundness supervisory process. While the banking agencies have tailored the Volcker rule and have proposed significant tailoring of incentive compensation rules, community banks and supervisors would benefit from not having to focus on regulatory compliance for matters that are unlikely to pose problems at smaller banks.”

Despite the positive self-evaluation, Yellen drew fire for regulatory moves that some saw as an overreach. There was also prevalent skepticism that—even if large, systemically important institutions are safer today than they were before the Great Recession—that the scourge of “too big to fail” has been reigned in.

NEXT STEPS IN EVOLUTION OF STRESS TESTING

The following is from a Sept. 26 speech by Federal Reserve Governor Daniel Tarullo, “Next Steps in the Evolution of Stress Testing," delivered at the Yale University School of Management Leaders Forum.
[The] set of changes we are considering for our stress testing regime has been motivated by somewhat different considerations, against the backdrop of what we intend to remain a dynamic regulatory instrument whose procedures will be regularly refined and whose substance will be regularly adapted to changing economic conditions and industry practices. Still, in pulling this package of modifications together, we have consciously shaped them in accordance with the principle that financial regulation should be progressively more stringent for firms of greater importance, and thus potential risk, to the financial system. Two features of the package reflect this principle.
First, of course, is the elimination of the qualitative portion of Comprehensive Capital Analysis and Review for nearly all the firms with less than $250 billion in assets, along with some record keeping and reporting requirements.
The second key feature is the differential impact the better alignment of CCAR with our capital regulations will have on the roughly 30 firms that are covered. Let me note at the outset that the precise effects on the capital requirements of individual firms cannot be determined because of the very nature of the stress test regime. The scenarios vary from year to year, and the resulting projected effects on losses and revenues may also vary materially depending on the composition of a firm's balance sheet and activities. However, to provide some idea of what the impact may be, we assessed how the various changes I have mentioned would have affected capital requirements in the two most recent CCAR cycles. On average for the eight GSIBs, integration of the surcharge with the post-stress requirements would have been somewhat less than half offset by the simplifying changes in the prefunding of capital distributions and balance sheet assumptions. The impact on capital requirements will likely be greater for firms with larger GSIB surcharges.
For the other CCAR firms, for which there are no capital surcharges, these simplifying assumptions will result in some reduction of post-stress capital requirements. We estimate that the aggregate impact of these changes for the CCAR firms as a whole should be a modest increase in the total amount of required capital. But this increase will be totally due to the impact on the eight GSIB firms, whose increased capital requirements will more than offset the reductions for the other firms.
In short, the GSIBs will see their capital requirements rise. All other CCAR firms will see some reduction in their capital requirements. And firms that have less than $250 billion in assets and do not have extensive international or nontraditional banking activities will also transition to a more tailored set of capital planning expectations outside the CCAR process.
Source: Federal Reserve

Rep. Frank Lucas (R-Okla.) expressed particular concern about the proposed rule that would curtail banks’ commodity holdings. It would “increase the cost for financial companies to engage with their clients in physical commodity markets, he said, stressing the importance of “stable commodity markets.”

“While we should, of course, continue to address risks to safety and soundness within our financial system, it appears that this rule simply seeks to discourage a company’s participation in these activities through capital requirements, rather than through an actual effort to target and mitigate risk within the system,” he said.

“We did take a very careful look at the nature of banks involvement in these areas and considered the risks that the activity entails,” Yellen responded. “It is important to recognize that financial holding companies would still, under these proposals, be permitted to engage in physical commodities trading with end users. That’s not something that would change.” The concern, she said, is that an environmental disaster, such as the infamous Deepwater Horizon oil spill, could threaten the financial stability of an involved bank.

“It is not a question of going back through history to see what happened in the past,” she added. “It is a forward-looking concern that permissible activities could pose risks.”

Rep. Randy Neugebauer (R-Texas) was not persuaded. “I’m afraid that we are just trying to think of things that could happen and then trying to make all of these financial institutions somehow pay a punitive penalty in either capital or regulation for events that may never happen, or may never happen again.”

Recent signals from the Federal Reserve regarding merchant banking also engendered pushback. In a recent report to Congress, it recommended that legislators repeal banks’ ability to conduct merchant banking, holdings of equity ownership in non-financial commercial companies.

Among the industry groups opposing such a move are The Clearing House, American Bankers Association, Securities Industry and Financial Markets Association, Financial Services Roundtable, and Financial Services Forum. In a joint statement they called the idea “unfortunate and ill-considered.”

“For the last 15 years, bank holding companies have successfully used the merchant banking authority granted to them by law to finance start-ups and growing companies, fueling jobs and economic growth,” they wrote. “They have done so without any threat whatsoever to the safety and soundness of their affiliated banks or to the financial system at large. The regulators have made these recommendations without pointing to any evidence that these activities have ever posed any problem, and have made no attempt to assess the costs to businesses and jobs. They have not provided a cost-benefit analysis or a robust justification for such sweeping changes to laws that were heavily negotiated over a very long period of time and by several administrations.”

“We seem to be intent upon finding a solution where there is no problem,” said Rep. Blaine Luethemeyer (R-Mo.).

As seems to be the case whenever bank regulation is the topic these days, the revelation that Wells Fargo employees opened nearly 2.5 million unauthorized customer accounts and credit cards was raised. Rep. Brad Sherman (D-Calif.) was among those suggesting that its executives’ failure to detect and rectify the illicit accounts makes the case that it is too big to manage and should be broken up. “Whether fault is the regulators who cannot regulate it or the managers who cannot manage it, too big to fail is too big to exist,” he said.

“The good news is that we are seeing banks taking bolder steps to reduce risks and to exit out of certain risky activities,” said Rep. Gregory Meeks (D-Calif.) “Not only have banks exited some of their riskier businesses, they have also boosted their capital and liquidity buffers, which surely increases the size of their balance sheets but it makes them safer and sounder institutions. And yet, we still have Wells Fargo, which causes us to have great concerns as to where we go next.”

Yellen said that in response to the scandal the Federal Reserve has initiated a review of all of the largest banking organizations regarding the problematic cross-selling practices that were at the root of Wells Fargo’s troubles. “We are very concerned with all of the compliance problems and violations of laws that have occurred,” she said, adding that her agency will take a “comprehensive look at the biggest banks for internal controls issues.”

“It is very important that senior management be held accountable,” she added.

Rep. Stephen Lynch (D-Mass.) urged an end of admissions without guilt and the drought of personal liability. “There is value in getting after them,” he said. “I don’t care if you get a conviction or not, just get after them and make their life hell. We need to create a disincentive for these CEOs to do the wrong thing. They completely ignored any of the safety and soundness and basic responsibilities here and I would like to see somebody held accountable.”

While many took encouragement from Yellen’s intention to ease the regulatory burden on community banks, those promises failed to please everyone.

“The big banks have hijacked the term community bank,” argued Rep. Al Green (D-Texas). “The big banks have concluded that you can be a $50 billion bank, even a $100 billion bank, and still be a ‘community bank.’ The big banks step in and they want all of the benefits that we would accord the smaller banks, the real community banks. There are people in Congress who would like to help community banks, but we cannot do it at the risk of bringing in the big institutions who would benefit from it to the detriment of what we have been trying to do with Dodd-Frank.”