Democrats argue Powell's Fed has eased stress tests and capital rules for big banks

Federal Reserve Board Chairman Jerome Powell appeared before the Senate Banking Committee and House Financial Services Committee this week to offer his semiannual report on monetary policy. Powell's remarks on issues such as interest rates, inflation, unemployment, wages and economic growth, as well as trade and tariff issues, were widely reported elsewhere — but Powell also addressed financial regulatory issues such as the implementation of a recent bill easing Dodd-Frank rules for smaller banks; claims that the Fed has relaxed capital and stress-testing rules since his arrival; the regulators' re-proposal of the Volcker Rule; and the status of a Dodd-Frank rule on incentive compensation.

Materials from the Senate Banking Committee hearing on July 17 are posted Powell told him, "I know that we're working on it now … . I can't give you an exact date, but I know we're actively drafting a rule. And by not being able to provide interim relief, all we meant was [that] we actually have to amend the rule. So, we'll be putting a rule out for proposal and get comments."

Robert Menendez (D-NJ) asked about the status of the long-delayed Dodd-Frank Title IX rules on incentive compensation and clawbacks. "Regulators issued a proposal in 2016, but more than two years later, nothing has been finalized," he said. Powell said it was a multi-agency rule, and "we were not able to achieve consensus over a period of many years between the various regulatory agencies that need to sign off on that … . particularly for the largest institutions, we do expect that they will have in place compensation plans that do not provide incentives for excessive risk-taking. And we expect that the board of directors will make sure that that's the case … We've moved ahead through supervisory practice to make sure that these things are better than they were, and they're substantially better than they were." Menendez replied, "That does not have the power of a rule."

Like Sen. Brown, Elizabeth Warren (D-MA) said that since Powell had taken over, "the Fed has rolled back" the key Dodd-Frank reforms of higher capital standards and stress tests. She said the Fed in April had proposed an amendment lowering the enhanced supplementary leverage ratio (ESLR), which the FDIC said would allow banks to hold $121 billion less in capital. Powell said, "We actually think that the effect of that proposed change … would be pretty close to zero as it relates to the firm itself … . If you look at the entire entity, it would be less than $1 billion. I won't say zero, but I think our estimate was $400 million." He said the FDIC's estimate was focused on the bank, "whereas we're talking about the whole firm … We don't want a leverage ratio to be the binding capital requirement, because if you're bound by that, you're actually called upon to take more risk."

Turning to stress tests, Warren said Powell's Fed had "weakened" the regime, noting that the central bank had not issued a "failing grade" to Goldman, State Street or Morgan Stanley when their capital plans were found inadequate. Powell said those banks had instead been given "a conditional non-object," but had nonetheless "suffered the same penalty, which was to have to limit their distributions to the prior years." Warren said the banks had not been required to submit new capital plans that would pass the test. "In the many times we've used that tool over the years we've not required that," Powell replied. Warren said, "because of your action, Morgan Stanley and Goldman Sachs investors took home about $5 billion more than they otherwise would have. That's a nice gift to the bank, Mr. Chairman. On top of that, the Fed also proposed a rule in April that would make the stress tests less severe — effectively reducing capital requirements at the eight largest banks by a total of about $54 billion," according to a Goldman Sachs analysis. Powell again argued that the stress test in 2018 was "materially more stressful. The amount of the loss and the amount of required capital to pass the test was the highest by far of any test." But Warren said, "The data don't seem to back you up on this. The Fed's capital requirements and the stress test are like a belt and suspenders: you can loosen the belt and rely on the suspenders, or you can take off the suspenders and rely on the belt. But if you do both, your pants will fall down."

From the Q&A at Powell's House Financial Services Committee Hearing, Wednesday, July 18, 2018

Blaine Luetkemeyer (R-MO) noted that former Fed Governor Daniel Tarullo, in a farewell speech, had said that stress testing programs should be moved into the normal examination cycle. He asked if Powell agreed, "or do you want to retain those as a separate type of testing that the banks are going to be putting out information for and modeling?" Powell said he believed Tarullo had been referring to the qualitative portion of the stress test: "We are looking to return the qualitative part of the test over time to the regular examination cycle … looking for the right way and time to do that." Luetkemeyer said he thought the stress tests are "a game of 'got you' — the models are not disclosed until the very last instance." Powell said, "We're working hard to make the qualitative side of the test … more transparent to the public generally and to the firms. And we think that that's a key innovation. We've got a proposal out on that."

Bill Huizenga (R-MI) said he had concerns about the re-proposal of the Volcker Rule. He asked how the new proposal would streamline compliance and clarify how the restrictions work. Powell said, "I think for the smaller institutions, we'll be streamlining quite a lot … . This rule is out for comment and we're very, very open to better ideas how to do this better. But we want to stay faithful to Congress' intent, which is these institutions, particularly the largest ones, should not have big proprietary trading businesses, shouldn't be doing proprietary trading as a business line." Huizenga said he had heard complaints from companies that the new proposal "has a new concept of using an accounting rule to identify [proprietary] trading, which were not included in the original Volcker rule. And I've been told that this could actually result in more activities getting caught up in the Volcker regime than there are pulled in today … My understanding is new metrics regime could result in roughly 50% increase in metrics reporting by the banks subject to the rule." Powell said, "That's not the intent at all. I assume we're going to see those comments through the comment process. And believe me, we'll give them careful consideration."

Later, Frank Lucas (R-OK) also asked about the re-proposal of the Volcker Rule. Lucas said he is concerned that regulators' interpretation of what constitutes a risky investment "has resulted in prohibitions on an activity that we want banks to engage in, such as making long-term investments in American companies to help them grow … Do you have any plans to modify the scope of the restrictions on bank's long-term investments in covered funds, so that the banks are able to serve as an important source of capital to these funds?" Powell again referred to the Fed's willingness to hear public comments on their new Volcker proposal: "I think we're bound by what the statute says, but within that we don't see this as an activity that typically threatens safety and soundness, so … we'd be willing to do whatever we can within the statutory language and intent to accommodate that activity."

Jim Himes (D-CT) asked Powell what risks to the banking system "keep him awake at night," if not capital ratio issues. "Is it student loans, is it proprietary trading, is it [exchange-traded funds]?" Powell said, "The clear answer to me would be cyber risk … The thing that is really hard is the idea of a successful cyberattack. And we work hard on having a plan for that … That would be the big one." In more traditional financial stability issues, Powell said, "risks are at the normal/moderate level. You see some high asset prices. You don't see high leverage among households or among banks. You do see a little bit of high leverage in non-financial corporates, and that's something we're watching very carefully. But nothing really is flashing red in our observation of it in the financial markets."

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