Yellen takes questions on stress tests, banks that failed their 'living wills,' capital & liquidity rules, forthcoming rules for insurers, lack of diversity at the Fed

The Senate Banking Committee today held a hearing to receive Federal Reserve Chairman Janet Yellen's semiannual monetary policy report to Congress. Yellen's remarks on interest rates, unemployment and job creation, "quantitative easing," economic growth, inflation, the potential for a "Brexit," and the decline of U.S. manufacturing were widely covered in the press. This alert covers questions she received on Dodd-Frank regulatory issues and other non-monetary subjects. Testimony from the hearing is posted here.

In an opening statement in which he criticized the Fed for not conducting its monetary policies according to a published rule, Chairman Richard Shelby (R-AL) added that he Fed's regulatory conduct has also "become increasingly opaque and complicated," with "inherent complexity and overlap in its capital and liquidity rules, stress testing, and resolution and recovery planning." Witnesses at a hearing two weeks ago had said "complex regulations might actually increase rather than decrease risk in the banking system," and its rulemaking process lacked analysis and transparency. Shelby said the same was true for the international Basel Committee's bank capital rules, which were simply imposed on U.S. banks "without adequate tailoring." That committee's analysis "included data from only 13 U.S. banks out of the 249 banks that were studied." He said Congress should consider mandating an analysis of the cumulative impact of capital and liquidity rules if the Fed will not do so voluntarily.

Federal Reserve Chairman Janet Yellen's prepared statement, which dealt exclusively with monetary policy, is posted here.

Questions

Stress Tests for 'Regional' Banks. In his questions, Chairman Shelby noted that in an interview this month, Fed Governor Daniel Tarullo had said the Fed is reviewing the application of stress test to regional banks, and had said the Fed would "probably" exempt regional banks from the qualitative portion of the Comprehensive Capital Analysis and Review (CCAR). Shelby said the Fed's "tailoring" of CCAR to regional banks had turned out to be "just a restatement of existing policy." He asked how Yellen could reassure the committee that the current effort would recognize "the different risk profiles of banks," and when this approach would be published for public comment. Yellen said this was a "five-year, very serious review" that would produce "meaningful changes" in how the Fed approaches stress tests. She said Tarullo had said that banks with assets between $50 and $250 billion might be exempted from "the qualitative portions of CCAR," such as capital planning requirements, though the stress tests would still apply. "I think that's very likely, we will look at other changes as well that, as you said, are designed to appropriately tailor it so that its impact is most significant for the largest and most systemic firms. It will be a very meaningful review and I believe we will be proceeding on it shortly."

Capital and liquidity rules for large banks. Ranking Member Sherrod Brown (D-OH) asked Yellen to discuss how the Fed's approach to capital and liquidity rules for the largest banks "made our financial system stronger." Yellen said the rules have made "an enormous difference to the safety and soundness of the U.S. financial system." She said the amount of capital at the largest banks "is essentially double from before the crisis, and the quality of that capital is very much higher." In addition to imposing higher risk-based capital and leverage requirements, she said the stress testing and capital planning exercises "are very detailed, forward-looking exercises" that will ensure that large banks in extremely stressful circumstances would still be able to support the credit needs of households and businesses. Yellen said the process has brought a "far superior understanding by the firms themselves of the risks they face and improved management of those risks." Because "liquidity is what disappears" in a crisis, she said the liquidity coverage ratio and the Fed's proposed net stable funding ratio have created a less crisis-prone financial system.

'Living Will' resolution plans

Several senators inquired with Yellen about the Fed's process for reviewing the resolution plans, or "living wills," that larger banks are required to submit under Dodd-Frank Section 165. Bob Corker (R-TN) said he was confused by recent remarks from Fed Governor Jerome Powell that "if the Fed just keeps raising capital levels, these institutions will own their own downsides or become less complex." If large banks cannot be resolved in bankruptcy, Corker asked, is the Fed going to follow Section 165, "or are you going to rely on raising capital to cause the banks to do it themselves?" Yellen said the Fed is insisting that "the firms address … deficiencies and shortcomings that we've found and enumerated it in the living wills and the last submission. There's a timetable for doing that. If the firms fail to address the deficiencies or if later on, by the summer of 2017, they fail to address the shortcomings, we will find them deficient. Dodd-Frank does say that the FDIC and the Fed can impose higher capital requirements, liquidity requirements or ultimately structural changes. [but I] don't expect to have to go there. But we are insisting that the firms address the deficiencies in shortcomings that we've carefully identified."

David Vitter (R-LA) noted that five of the largest U.S. banks had "failed" their 2015 living wills. He asked what the banks needed to do to pass, and if the Fed would take an action like raising their capital levels if the banks' resubmitted plans were also found deficient by October 1. Yellen said the Fed has been "extremely careful in spelling out in detail" what the failing banks' deficiencies are, and also listed "a large number of specific shortcomings that the firms have until the summer of 2017 to remedy." She said if those problems are not remedied, "They could turn into deficiencies that would lead us to impose higher capital standards or other remedies … if that isn't done." Yellen said she could not say that "at this point, all of [those banks] are prepared for resolution under bankruptcy." When Vitter asked if the banks have not passed by October 1, the Fed would "very soon thereafter consider something … like higher capital requirements," she said yes.

Elizabeth Warren (D-MA) also asked if the Fed would "use the tools that Congress gave you," such as raising capital levels, if the failing banks' living wills have not passed by October 1. Yellen said, "We've been very serious in this review of living wills and we have clearly stated a set of well-identified changes that we want to see by Oct. 1 … About what we do if those deadlines are not met … those are decisions that my colleagues and I will need to look at very carefully, what is the appropriate sanction. But clearly, we are very serious about wanting to see these deficiencies remedied … So I cannot pre-commit today to tell you precisely what our response will be, and we will work closely with the FDIC as we have all along." Warren said she couldn't understand why Yellen could not commit to specific measures, and that "if any of the banks fail the credibility test on their fifth try, they need to face some real consequences."

Insurance capital rules

Jon Tester (D-MT) noted that the Fed was moving forward with international insurance capital rules, as well as special capital rules for the two non-banks designated as SIFIs by the FSOC (AIG and Prudential). He asked when the rules might be completed. Yellen told him, "There are some ways to go in terms of the international work that's ongoing. We put out a few weeks ago an advance notice of proposed rulemaking [ANPR] for the framework that we intend to take here in the United States. We are in discussions internationally in advancing these ideas, but I think we are ahead of that process here in the United States." When Tester asked if the rules would be finished "in this administration," Yellen said she didn't know what the timetable was and she would have to get back to him.

Mark Kirk (R-IL) also addressed the Fed's forthcoming insurance rules, saying he and Susan Collins (R-ME) had been working to ensure that the Fed "recognizes the great difference between the business of banking and insurance," and he said the ANPR notice "heads in the right direction there." He said that within the ANPR's approach, "It seemed like the key stress test was a 90-day window of liquidity that … if you look at someone like State Farm that affects 80 million families, you would say the stress would be … 'Do you have enough money over 90 days to sustain the enterprise?'" Kirk urged Yellen to "make sure the normal Fed culture of bank regulation" does not create uncertainty in the insurance industry. Yellen said that was the Fed's intention, that the ANPR had put forward "some conceptual frameworks," and the Fed will consider public comments carefully "before we proceed with more detailed rules, and the Collins fix was very helpful to us in having the flexibility to design something that is appropriate for insurance and not bank-centric." Kirk said he would be "approaching members of this committee to also provide their comments" on the ANPR.

'Short-termism' by banks. In his questions, Mark Warner (D-VA) said he had seen data indicating that as few as 15% of financial institutions are engaged in activities to support businesses and make investments in communities, a decline from a much larger proportion in the 1980s. "Now we are seeing 95% of corporate profits used for stock buybacks and dividends … I think there's an increasing consensus among CEOs and sophisticated investors that this is long-term, destructive to real value creation in business." Yellen said the Fed has "looked very closely at investment spending and tried to understand why it has been so very depressed in the aftermath of the crisis." She said one reason was slow economic growth and low demand that did not require much investment in order to satisfy it, and a workforce that "expanding less quickly than it had been." Warner said some activist investors have argued that "the first thing you shut down are your worker training programs, your investment in infrastructure, and I believe that is a negative long-term."

Banks' ownership of commodities. In his questions, Jeff Merkley (D-OR) said, "One of the issues that I've raised multiple times is the Fed's power over the conflict of interest in commodities — the ability of large financial institutions to own pipelines, to own ships full of oil, to own energy generation stations, to own warehouses of aluminum. And each time I hear we're looking at that, are we still looking at that? Are we actually going to do something about that?" Yellen said, "We'll come out with a proposal on that. But some of it reflects decisions that Congress made, and not Fed policy."

Diversity in the Fed system. At various points during the hearing, Ranking Member Brown, Sen. Warren and Robert Menendez (D-NJ) all took Yellen to task for reports that the Fed lacked diversity among the officials in its network of regional banks. Brown faulted "the lack of diversity in terms of gender, ethnicity and race, and the lack of diversity in ideas that are the Class C directors in many of your 12 Federal Reserve [Banks] around the country." Menendez told Yellen, "There is not a single president who is either African-American or someone like me, Latino. That is fundamentally wrong." Yellen said, "I am personally committing, and the Federal Reserve as an organization is committed to, achieving diversity within our workforce and within our leadership at absolutely all levels … I am committed to seeing us make further progress and in order to make sure that we're taking all of the steps that we possibly can to promote diversity and economic inclusion."

If you have questions, or need additional information, please contact Will Heyniger or Bob Schellhas at Washington Council Ernst & Young at (202) 293-7474.

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