The year 2017 was an active one for supervision and regulation. At the Fed, Governor Randal Quarles has been confirmed as the vice chair for supervision, and Governor Jerome Powell is on track to be confirmed as the new chair of the Board of Governors. Congress is considering several legislative proposals that would adjust certain regulatory aspects put in place by Dodd-Frank.
In the international arena, the four bank regulatory agencies just endorsed the completion of the Basel III international capital standards, which many see as fundamental to maintaining and improving international financial stability. The agencies will consider how to apply these standards in the United States.
All the while, supervisory agencies have continued to focus on reducing the regulatory burden, clarifying supervisory expectations, and refining enhanced prudential standards. Such steps adopted in the last 18 months include streamlined Call Report requirements, an expansion of eligibility for an extended examination cycle, and an increase in the threshold of the Board's small bank holding company policy statement.
The Federal Reserve's perspective
Several Fed officials have publicly expressed support for increasing the statutory thresholds in Dodd-Frank to focus on the firms that pose the greatest risk to the financial system and reduce the regulatory burden for smaller, less risky firms. Such action could include raising the thresholds for stress testing and risk committee requirements (which now apply to firms with $10 billion or more in assets) and enhanced prudential standards. These standards apply to systemically important financial institutions (SIFIs), those with $50 billion or more in assets.
Additionally, Fed officials have discussed support for exemptions from the Volcker Rule and incentive compensation requirements for smaller firms. Congressional action would be required to raise Dodd-Frank thresholds and make changes to the application of the Volcker Rule.
The Board of Governors is reassessing some prudential standards, including the enhanced supplementary leverage requirement, and is considering ways to improve implementation of the Volcker Rule. In addition, the Fed and the Federal Deposit Insurance Corporation (FDIC) continue to explore ways to streamline the resolution planning process to improve focus on the largest firms.
In June, in a statement to Congress on the relationship between regulation and economic growth, Governor Powell outlined four guiding principles to simplify and reduce regulatory burden:
- Protect the core elements of the reforms in capital and liquidity regulation, stress testing, and resolvability.
- Continue to tailor requirements to the size, risk, and complexity of firms, being mindful that community banks face higher costs to meet complex requirements.
- Assess whether regulation can be adjusted in commonsense ways to simplify rules and reduce regulatory burden without compromising safety and soundness.
- Strive to provide appropriate transparency to supervised firms and the public regarding supervisory expectations.
Recent proposals
In keeping with these principles, regulators have recently issued several requests for comment on proposed regulatory changes. These proposed changes would increase transparency in the regulatory process, clarify supervisory expectations, and simplify regulatory burden. Regulators developed them in response to the Fed's ongoing internal review of regulatory requirements and to comments from the industry. The current requests for public comments concern proposals to enhance the information provided about the Board's stress testing program, simplify regulatory capital requirements, provide guidance on boards of directors' governance of financial institutions, and outline a proposed new rating system for large financial institutions (LFIs).
Increasing transparency in stress testing
Most recently, on December 7, 2017, the Board of Governors issued a package of three proposals covering enhanced model disclosure, changes to the scenario design framework, and a new stress testing policy statement. These proposals would increase transparency of the Board's stress testing program. Comments on the measures will be accepted through January 22, 2018.
The first proposal for enhanced model disclosure includes three parts.
- It would provide more detailed descriptions of supervisory models, including key variables and certain equations that influence the results of those models.
- It would disclose loss rates on loans grouped by important risk characteristics and summary statistics associated with the loans in each group.
- It would share hypothetical portfolios of loans with loss rates estimated by the Board's models. Such sharing would include the release of factors used to estimate losses in the stress tests, providing more detail on how different types of loans are treated under stress and insight into how annual results are evaluated.
The proposal is designed to further enhance the public's understanding of the supervisory stress test models without undermining the effectiveness of the stress test as a supervisory tool.
The second proposal seeks comment on changes to the Board's scenario design framework for stress testing, which was originally issued in 2013. The proposal arose from the Board's annual review of the stress testing program as well as feedback received from industry participants. The proposal includes three modifications to the hypothetical scenario design framework. These include a description of the circumstances in which an increase in the unemployment rate would be warranted and an explicit guide for arriving at house prices in the severely adverse scenario. In addition, the Board leaves open the possibility of considering an increase in the cost of funds as an explicit factor in the scenarios.
The third proposal asks for comments on a "stress testing policy statement," which would describe the Fed's approach to model development, implementation, use, and validation. The statement would elaborate on prior disclosures and provide details on the principles and policies that guide the development of the Fed's stress testing models. The proposal would complement the Board's scenario design framework.
Simplifying the Regulatory Capital Framework
On September 27, the Office of the Comptroller of the Currency, the FDIC, and the Federal Reserve requested comment on a proposal to simplify regulatory capital requirements. The proposal arose from comments received during a review of the Economic Growth and Regulatory Paperwork Reduction Act. Most aspects of the proposed rule would apply only to banking organizations exempt from the advanced approaches capital rule, which are firms with under $250 billion in total consolidated assets and less than $10 billion in on-balance-sheet foreign exposure.
The proposed rule would replace the definition of high-volatility commercial real estate exposures in the standardized approach capital framework with a definition for higher-risk acquisition, development, or construction loans called high-volatility acquisition, development, or construction. The new definition is more straightforward. The rule would also simplify the threshold deduction treatment for mortgage servicing assets, certain deferred tax assets arising from temporary differences, investments in the capital of unconsolidated financial institutions, and capital issued by a consolidated subsidiary of a banking organization and held by third parties (minority interests).
Clarifying the role of the board of directors and senior management
In August, the Fed requested comment on proposed guidance on supervisory expectations for the boards of directors of financial institutions. The results of a multiyear Federal Reserve review of board practices form the basis of the proposal. The comment period is open through February 15, 2018.
The review revealed that firms believe it has become difficult to distinguish between the duties of directors and those of senior management. This confusion detracts from directors' focus on their core responsibilities, which promote safety and soundness, to noncore tasks, which senior management should handle. The review also found that directors are facing information flow challenges that could impede their ability to exercise appropriate governance. The proposal is designed to address these concerns, improve oversight at larger firms, and reduce the regulatory burden on smaller institutions.
The first part of the proposal, Board Effectiveness (BE), offers guidance that identifies five attributes of effective boards, including setting a clear and consistent strategic direction for the firm as a whole, actively managing information flow and board discussions, holding senior management accountable, supporting independent risk management and internal audit, and maintaining a capable board composition and governance structure.
The Fed proposes to use its assessment of these attributes as the framework for reviewing the performance of the board of directors under the proposed LFI rating system, which is discussed in more detail below.
The second part of the proposal involves rescinding or revising existing Federal Reserve expectations for boards of directors. The Fed is conducting a two-phase review to identify expectations that do not relate to a board's core responsibilities or are not aligned with the Fed's supervisory framework. The first phase includes reviewing existing supervision and regulation (SR) letters. This review has identified 27 SR letters, which include more than 170 supervisory expectations for holding company boards of directors. The second phase involves reviewing expectations in the Fed's regulations and interagency guidance. A proposal based on the second phase of the review will be released at a later date.
The third part proposes the revision of SR letter 13-3, Supervisory Considerations for the Communication of Supervisory Findings, to indicate that matters requiring attention (MRAs) and matters requiring immediate attention (MRIAs) should, in the normal course of business, be directed to senior management and not to the board of directors. MRAs and MRIAs would be communicated to the institution's board for corrective action only if it needed to address its governance responsibilities or if management had failed to take remedial action in a timely manner.
Considering a new LFI rating system
In August, the Board also requested comment on a proposal for a new rating system for financial institutions with $50 billion or more in assets. The new rating system would better align with the postcrisis supervisory program for large institutions. The LFI rating proposal differs significantly from the existing RFI (risk management, financial condition, subsidiary impact) rating framework, which will remain in effect for bank holding companies with less than $50 billion in assets.
The LFI rating system would include separate ratings for three components: capital planning and positions, liquidity risk management and positions, and governance and controls. The governance and controls rating would evaluate the board of directors' performance based on the attributes identified in the director guidance discussed above. As proposed, a composite rating would not be assigned for LFIs. The Fed believes that a composite rating could dilute the information provided for each core area assessed. Each component would receive a rating using a multilevel scale. The Board plans to begin using the new rating framework in 2018.
Looking ahead to 2018
In 2018, the Federal Reserve will continue to look for ways to improve supervision and regulation by tailoring supervisory expectations based on the size and complexity of activities while ensuring resilience to systemic shocks. Cybersecurity, including the potential risks posed by some fintech activities and cryptocurrencies, is a high priority for the banking agencies and the industry.
Recently, Governor Powell noted that "Policymakers and the financial industry must assure that enhanced convenience and speed in financial services do not undermine the safety, security, and reliability of those services." Furthermore, Governor Quarles has proposed that the Board take the lead in facilitating communication on cyber threats to financial institutions. Much more remains to come.