Quarles discusses Fed's capital and leverage proposals, disclosure of stress test models, Volcker Rule, Fed's input into bank boards; says CRA must be taken off 'autopilot'

The House Financial Services Committee on April 17, 2018, held a hearing to receive "The Semiannual Testimony on the Federal Reserve's Supervision and Regulation of the Financial System." The only witness was Fed Vice Chair of Supervision Randal Quarles, in his first appearance before the committee since his confirmation. Testimony from the hearing is posted here.

In his opening statement, Chairman Jeb Hensarling (R-TX) said the committee had been "waiting eight years" for his arrival, noting that President Obama had not appointed anyone to Quarles' position though the 2010 Dodd-Frank Act had mandated it, so former Fed governor Daniel Tarullo had effectively held the job without congressional oversight. Hensarling praised the Republican tax reform bill Congress passed in December, and said that Dodd-Frank, "regardless of what it may have done for financial stability, is perhaps the most complex, costly, confusing regulatory onslaught onto our capital markets that we have seen," and some believe it cut the U.S. GDP by 0.5 to 1%. Hensarling said he appreciated Quarles' call for efficiency to make sure that, in Quarles' words, "the cost of regulation in reduced economic growth or increased frictions in the financial system is outweighed by the benefits of the regulation."

In her opening statement, Ranking Member Maxine Waters (D-CA) said she was encouraged when the Fed took action against Wells Fargo under former chair Janet Yellen "for its egregious consumer abuses and capped the bank's growth until it cleans up its act." She said the Trump Administration and Republicans in Congress "are working to move our system of banking regulation in exactly the wrong direction in their efforts to dismantle the crucial reforms that Democrats put in place in Dodd-Frank," despite the fact that banks "of all sizes" are now earning "record profits." Waters said she is concerned about a recent proposal from the Fed to lower the capital buffer for the eight largest banks by what she called a combined $112 billion. Under this proposal, she said, "Wells Fargo … would be allowed to hold $20 billion less in capital than the current standard for a well-capitalized bank of its size."

In his prepared statement, Federal Reserve Vice Chair of Supervision Randal Quarles said that under its new leadership, the Fed's regulatory and supervisory agenda is to "improve the effectiveness of the post-crisis framework through [the] principles of efficiency, transparency and simplicity." He noted that last week, the Fed and the OCC had issued a proposal to recalibrate the enhanced supplementary leverage ratio (ESLR) for large, global systemically important banks (G-SIBs). The proposal would make the ratio "less likely to act as a primary constraint, which can actually encourage excessive risk-taking, while still continuing to serve as a meaningful backstop." Quarles said the Fed last year adopted a rule eliminating the so-called qualitative objection of the Fed's CCAR exercise for mid-size firms. "As a result, deficiencies in the capital planning processes of those firms will be addressed in the normal course of supervision," he said, adding that he believes this approach "should also be considered for a broader range of firms," thus the Fed last week had called for public comment on such an expansion. Quarles said he supports efforts in the House and Senate to further tailor regulations to a bank's size, and believes the Fed should "take concrete steps toward calibrating liquidity coverage ratio requirements differently for non-G-SIBs than for G-SIBs. I also think we can improve the efficiency of our requirements regarding living wills."

Quarles noted that late last year, the Fed proposed an enhanced stress testing transparency package, which would "provide greater visibility into the supervisory models that often determine [the banks'] binding capital constraints. And we're continuing to think about how we can make the stress testing process more transparent." He also highlighted a proposal the Fed released last week that would "effectively integrate the results of the supervisory stress test into our non-stress capital requirements." For the largest banks, he said, the change would reduce loss absorbency requirements from 24 to 14. "We estimate the proposed changes would generally maintain — in some cases, modestly increase — the minimum risk-based capital required for the G-SIBs, although no bank would actually be required to raise capital because their existing capital levels are well above those minimums, and modestly decrease the amount of risk-based capital required for most non-G-SIBs." He said the Fed is working with other regulators to "further tailor implementation of the Volcker Rule, and to reduce burden for firms that do not have large trading operations and don't engage in the sorts of activities that may give rise to proprietary trading."

Questions

Bank boards, directors, lobbying. In his questions, Chairman Hensarling said a number of financial firms had told the committee that "representatives of the Fed have insisted on attending" meetings or hearings of their boards of directors; he asked if the Fed has the legal authority to do that. Quarles said he would have to respond later about the question of authority, but as to whether it was a wise policy, "we ought to be focusing … on ensuring that boards are structured in order to be able to do their jobs." He said the Fed last August had issued a "board effectiveness guidance proposal" intended to "to scale back some of the excessive micromanagement" and "misdirection" of bank boards. Hensarling said he had heard that some Fed examiners have recommended to management that certain board members should be fired. Quarles told him that such a recommendation "probably shouldn't be something that, at the direct supervisory team level, would be engaged … those would be extremely rare cases, I think." When Hensarling said that "one large diversified financial services company" had said their examiners question them about their lobbying activities, Quarles said he couldn't think of a reason why that would be appropriate.

Redlining and CRA ratings. Ranking Member Maxine Waters (D-CA) referred to a report by the Center for Investigative Reporting that had surveyed 31 million loan records, concluding that "lending patterns in Philadelphia today resemble redlining maps drawn across the country by government officials in the 1930s." Nonetheless, she said 99% of U.S. banks got a "satisfactory" rating under the Community Reinvestment Act (CRA). Quarles said regulators were currently focused on this issue and the Treasury Department had released a report offering ways to improve and "invigorate" the application of CRA. He said the Treasury report "lays out a good framework for consideration," but the agencies will have to decide many details. When Waters asked about the disparity between satisfactory CRA ratings and the apparent persistence of redlining, Quarles said, "one of the issues that I … have seen with respect to CRA is that, over the years, it has become a little formulaic and ossified … moving CRA off 'autopilot' … is something that we should be doing."

Custody banks & leverage ratio. In her questions, Carolyn Maloney (D-NY) said Senate Banking Committee Chairman Mike Crapo's (R-ID) bipartisan regulatory relief bill (S. 2155), which passed the Senate in March, includes a provision that would allow custody banks to exclude reserves that they hold at the central bank from the supplemental leverage ratio (SLR). She noted the Fed and the OCC last week had proposed an amendment to the SLR that intended to address the same custody bank issue. She asked if such a regulatory change would make section 401 of the Crapo bill "unnecessary." Quarles said the goal of both efforts is "adjust the ESLR so that it is not a primary binding measure, because when you have a leverage ratio that is creating incentives for decisions at the margin, because that leverage ratio isn't risk-sensitive, that means that your decisions at the margin will not be risk-sensitive. You'll have an incentive to basically take on more risk. So I think it is important to calibrate that down." He said if the Senate provision becomes law, "We would then have to consider how to calibrate our proposal to take account of the fact that certain banks would have had the denominator of the ESLR changed for them."

Later, Nydia Velazquez (D-NY) noted that FDIC Chairman Martin Gruenberg had not signed on to the Fed's leverage ratio proposal because it would reduce capital requirements for the largest banks, which he called "the most important" of the post-crisis reforms. Quarles said the new emphasis on leverage capital ratios was something he himself had learned from the crisis. But he said such ratios should be a "backstop," and "the most effective and efficient capital ratios are those that are risk-sensitive," repeating his assertion that leverage ratios could create "a regulatory incentive for that institution to add risk, rather than to reduce risk." He called the proposed capital reduction "relatively modest … a few hundred million dollars out of the many, many, many billions of dollars of capital in the system against the benefit of changing that incentive."

Transparency of stress test models. Rep. Maloney noted that the Fed in December had proposed a package of changes designed to increase the transparency of the Fed's stress test regime, saying she believes that proposal would be "more than adequate" to address transparency issues. She asked why Quarles believes additional disclosures about the stress test models are necessary. Quarles said the Fed is examining public comments on the proposal and he didn't want to "say exactly where we'd land," but "one example that we do want to consider … is with respect to the scenario design itself, as opposed to simply the models that are used in the stress test … the credibility of the scenarios would benefit from … some appropriate period of input from the public on those scenarios, each year."

Later, David Scott (D-GA) said that in Rep. Lee Zeldin's (R-NY) Stress Test Improvement Act (HR 4293) that passed the House last week, he had negotiated language requiring the Fed to publish their stress test scenarios, because "the Fed must be very, very careful not to expose how they're going to conduct these stress tests. Because … if a bank is aware in advance of how you're going to do the stress testing, then that bank will be able to optimize its balance sheet for that particular day on which you're doing the stress test." For that reason, Scott said he disagreed with Quarles' contention that additional disclosures about the regime are appropriate.

Andy Barr (R-KY) also brought up the stress test models, mentioning the Fed's recent proposed rule for a "stress capital buffer" and asking if Quarles agreed with his predecessor Daniel Tarullo that "the qualitative assessment in CCAR be phased out for all banking organizations." Quarles said, "That's something that we should consider and have called for a comment on." Barr said the main driver of the stress tests is "the severely adverse scenario. And it has been published by the Fed without the benefit of any public comment or external review. And the model that will be employed to calculate the bank's stress losses using that severely adverse scenario is the Fed's proprietary model, but is there no transparency" regarding how the model and the minimum capital requirement are determined. He asked if the Fed is open to publishing those scenarios for comment. Quarles said, "I think we need to get more public input on them. A full … notice and comment process, which could take years … might be logistically difficult. But I think that there are ways that we can get genuine, serious input and still be consistent with the purposes of the test. I agree with you."

Revising Volcker rule. In his questions, Bill Huizenga (R-MI) asked about the status of the five regulators' efforts to revise the Dodd-Frank Volcker Rule, which bans proprietary trading by banks. When Huizenga asked if the rule as currently drafted is "detrimental to capital markets right now," Quarles said, "I think that's unarguable," adding that the burdens imposed by the rule include "a great deal of uncertainty" and cost, though economists would argue about its effect on liquidity. Quarles said it was not possible for regulators to repeal the rule, and "there are certain limits on our ability to make changes that we might otherwise have thought appropriate, because of the terms of the statute itself." But he said regulators could increase the certainty, and reduce the burdens, of how the rule is applied.

Federal Reserve reform bill. Rep. Barr said that "given the Fed's enormous new supervisory and regulatory powers now, an argument can be made that the Fed should be made more, not less accountable to Congress." He asked for Quarles' take on Warren Davidson's (R-OH) Federal Reserve Regulatory Oversight (FORM) Act (HR 4755), which would bring the Fed Board's non-monetary-policy-related functions into the appropriations process. Quarles said he had "wrestled" with these issues, trying to balance the priority of accountability with that of the Fed's independence, but said he is "concerned that [the bill] would, because of the fungibility of money, create the possibility for some future Congress to put pressure on the monetary policy side."

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

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