Yellen takes questions on Volcker Rule, stress tests, orderly liquidation, Wells Fargo's board, supplementary leverage ratio

The Senate Banking Committee on July 13, held a hearing to receive the Federal Reserve's semiannual monetary policy report. The only witness was Fed Chairman Janet Yellen. Unlike the previous day's hearing with Yellen at the House Financial Services Committee, much of the questioning concerned financial regulation as opposed to monetary policy. Testimony from the hearing is posted here.

In his opening statement, Chairman Mike Crapo (R-ID) said the committee had received more than 100 submissions from individuals and stakeholders for regulatory relief proposals aimed at spurring economic growth, and he and Ranking Member Sherrod Brown (D-OH) are "working together now to put together legislation dealing with it." Crapo said they were focusing particularly on "bipartisan solutions to tailor regulations, change the SIFI threshold, exempt certain firms from stress testing, fix the Volcker rule and simplify small-bank capital rules. These are just a few of many issues raised." He singled out the Dodd-Frank Act's $50 billion asset threshold for SIFI banks as "an area which we should address," given that several officials at the Fed and OCC had expressed support for raising it. Crapo also said that "reforming the housing finance system is one of my key priorities this Congress," noting that Fed Governor Jerome Powell had given a speech last week in which he said "the status quo is unsustainable."

In his statement, Ranking Member Brown was critical of deregulatory efforts that he said were too broad. "Gutting protections for working Americans is back in style in parts of Washington, from the Treasury Department's report, to the [House-passed] Financial CHOICE Act, to the House's financial appropriations bill. We face a slate of nominees for watchdog positions who are … of Wall Street, by Wall Street and for Wall Street. Everyone on this dais can agree there are parts of Wall Street reform that could be improved … But our focus should be on growing a stronger economy for everyone in every part of the country."

Chairman Crapo said that by agreement, Federal Reserve Chairman Janet Yellen would not read her prepared statement because it had not changed from the statement she read Wednesday on the House side.

Questions

Chairman Crapo asked if Yellen agreed with Fed Governor Powell's remarks last week in support of a bipartisan push in Congress for housing finance reform, toward a new system that would make bailouts "remote" and "attract large amounts of private capital." Yellen said she supported Powell's principles: "It's been almost a decade since Fannie and Freddie were moved into receivership, and the role of the government and the associated systemic risk remains, and I think it's important to move forward with reforms." Crapo asked her to provide for the record "some additional suggestions of ideas or legislation the committee could consider to reduce the burdens in these areas."

Crapo also noted that Powell had said the Fed is reviewing the Volcker Rule, which bans banks from proprietary trading except for certain situations, and he asked for Yellen's view on that effort. Yellen said, "It's a very complex rule … But I think we could find ways to reduce the burden, and it should be a multi-agency effort." When Crapo asked her about the idea of naming one agency to lead any regulatory action on Volcker, Yellen said, "I think that's something that Congress could certainly consider. If one agency has a larger regulatory role with respect to those institutions, might be natural for it to take the lead."

Ranking Member Brown said the Treasury's recent report offering recommendations for relief from a number of financial rules would "weaken regulations on the largest banks, including lower capital requirements and fewer consumer protections." He asked if Yellen would still have the same confidence in the financial system if these were adopted. Yellen said she "wouldn't be in favor of reducing capital for the most systemic banks … There are a lot of things in the Treasury report that we agree with, that mirror things that we're doing on our own to appropriately tailor regulations … But to those banks, it's critically important to maintain the capital standards." She agreed with Brown that adopting "some" of the report's proposals could make another financial crisis more likely.

Brown then noted that last year the Fed had proposed adding capital surcharges into the stress tests for large banks, and that former Fed governor Daniel Tarullo had said the biggest banks' capital requirements "are still somewhat below where they should be." He asked if the Fed is on track to finish those changes. Yellen said, "We're working very hard on those. We're awaiting further work by our staff. We hope to include those surcharges and make other adjustments and to better integrate the capital requirements relating to the stress tests into our normal capital regime." When Brown asked if that work would be done in time to integrate the surcharges into next year's stress tests, Yellen said, "It depends on the timing. We will need to go out with the proposal, and I can't guarantee that it will be in place that quickly."

Mark Warner (D-VA) noted that the Fed has "moved pro-actively" to scale back the qualitative portion of the "CCAR" test for banks with less than $250 billion in assets. He asked if Yellen could foresee more changes to CCAR, "and is there some value for continuing to keep CCAR in place for the largest institutions?" Yellen told him she thought the stress tests and CCAR have "very substantially strengthened" the largest banks. She said the Fed has looked carefully at CCAR and is open to more changes, but added, "Let me say that conducting these stress tests in a rigorous way and making sure that firms have the capacity to be able to meet our capital planning expectations … is critically important to having a sound financial system. I can't really see our putting the models into the public domain … It's conceivable that, one day, if the largest institutions were to show, on a regular basis, that they have in place very strong capital planning standards that meet our expectations — perhaps we could change the qualitative portion of the review for some of them, as long as we have that assurance. But that remains an open question."

Chris Van Hollen (D-MD) asked Yellen if it is important to preserve Dodd-Frank's provisions on orderly liquidation authority (OLA). Yellen said she believes it is "essential to maintain orderly liquidation. We saw during the crisis that the absence of a way to resolve a non-depository institution, a systemic financial institution, in an orderly way, led to a massive intensification of the crisis." She said that "we should work on the ability to resolve these firms under the bankruptcy code," and the "living wills" that large institutions must submit would help to resolve them in a crisis, as will higher capital levels, but "Title II [of Dodd-Frank] is a very important safeguard. We can't know exactly what the circumstances would be at the time that a firm encounters distress, and that is a very workable approach that I believe we absolutely need."

Van Hollen then asked about the House-passed CHOICE Act's provision allowing banks to be exempt from many prudential rules if they maintain a high leverage ratio. He noted that former Fed governor Tarullo had said such a shift "would allow banks to ditch safe assets in favor of riskier ones to boost profits." Yellen said she agreed with Tarullo, because "a simple leverage ratio basically imposes a capital charge on a junk bond that's identical to the charge that's imposed on holding a Treasury bill. And that type of system can result in banks' taking on a great deal of risk. So I believe risk-based capital should be the most important form of capital regulation, that that's what should be binding."

Elizabeth Warren (D-MA) devoted her questions to her argument that the Wells Fargo board members who served when the bank went through its "fake accounts" scandal should be removed. Warren said Yellen's reply to her letter had acknowledged the Fed has the authority to remove those board members, and "confirmed that you're willing to use that authority if it is warranted." She questioned how removing the members could not be warranted, since the Fed has established tough, post-crisis standards for risk management requiring boards to ensure that banks have "processes and systems for ensuring effective and timely implementation of actions to address emerging risks … Wells Fargo didn't come close to meeting those requirements," because of its cross-selling goals and compensation structure.

Yellen told Warren that she could not discuss a confidential supervisory matter, but "I will say that the behavior we saw was egregious and unacceptable, and it is our job to understand what the root causes were of those failures. And, as I've agreed, we do have the power, if it proves appropriate, to remove directors. A number of actions have already been taken, and we need to conduct a thorough investigation, to look at the full record to understand the root causes of the problems. And we are certainly prepared to take enforcement actions if those prove to be appropriate." Warren said she was worried because "time after time, big banks cheat their customers, and no actual human beings are held accountable. Instead, there's a fine, which ultimately is paid for by shareholders, not by executives, and certainly not by directors of the board. And nothing's going to change at these big banks if that doesn't change … Fines are not working with these giant financial institutions. If bank directors who preside over the firing of thousands of employees for creating millions of fake accounts can keep their jobs, then I think every bank director in this country knows that they are bulletproof, and that poses a danger to the rest of us every single day."

Mike Rounds (R-SD) said he was pleased to hear Yellen's exchange with Sen. Van Hollen on the enhanced supplementary leverage ratio (SLR), because he is concerned about that rule's effect on custody banks. "For mutual fund holders, the cost for those [custody] banks is passed on directly to the mutual funds … I'm wondering if you've got a time frame or a concept in terms of how to address the increased costs that they have." Yellen said, "We are aware of the issues faced by the custody banks. It's one of the reasons that we're looking at the issue of the appropriate calibration of the enhanced [SLR] for those banks; perhaps it's too high, relative to risk-based capital requirements … This is something that needs to be looked into. Different countries have taken different approaches. One approach is to exempt certain items, like central bank reserves, from the ratio. Another alternative is to recalibrate the ratio. I can't give you a definite timetable for our reconsideration of this, but it is something where, perhaps, our regulations had an unintended consequence, and we are looking at that carefully." When Rounds asked Yellen if she thought legislation might be necessary to make a change, she guessed it would not be, "but I will get back to you if that's not the case."

Tim Scott (R-SC) said the term of the Financial Stability Oversight Council's (FSOC) member with insurance expertise, Roy Woodall, is set to expire in September, and asked if Yellen would support legislation to "make sure that insurance expertise stays on FSOC." Yellen said, "I do think it's important for FSOC to have insurance expertise, and exactly how you go about accomplishing that, I don't have a specific recommendation."

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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