The House Financial Services Committee, on November 14, 2018, held a hearing to receive twice-yearly testimony on bank regulation from Randal Quarles, the Fed's vice chair of supervision. It was the first hearing the committee has held since the midterm election, in which House Democrats won the majority for the next Congress. Testimony from the hearing is available here. Quarles was the only witness.

In his statement, Chairman Jeb Hensarling (R-TX) said he wanted to "acknowledge and congratulate my friends on the other side of the aisle for their victory" and said that while he is retiring, he will "do everything today to ensure that there will be an efficient and peaceful transfer of power." Turning to the framework the Fed proposed on October 31 for how to tailor supervision of banks with assets between $100 billion and $250 billion, per the authority given by S. 2155 (the Economic Growth, Regulatory Relief, and Consumer Protection Act), Hensarling said, "These proposals are a most welcome sign of progress. But to be clear, they do not yet represent success. If they represent the Fed's final offerings, it's pretty thin gruel." Hensarling said he was pleased that the Fed is willing "to better tailor, perform cost-benefit analysis, implement prudential regulatory risk adjustments and propose amendments to the Volcker Rule," though he said those were simply first steps and are not sufficient to "propel our economy to sustained 4% economic growth."

In her statement, Ranking Member Maxine Waters (D-CA) thanked Hensarling for his words and said she is "always amused that the press can't seem to get our relationship right." Waters said she is "concerned about proposals the Fed has put forth this year to reduce capital and liquidity requirements for the largest financial institutions." She mentioned a letter she had sent with 18 other Democrats in September urging the Fed to maintain strong capital requirements for global systemically important banks (GSIBs). Waters said these rules have strengthened the financial system without undermining economic growth, as evidenced by data showing that bank lending to business has increased 80% since 2010. "Banks of all sizes are making record profits. On average, they have made $167 billion in profit annually the last three years," she said.

Federal Reserve Vice Chair for Supervision Randal Quarles' prepared statement, in which he described the Fed's efforts to "improve regulatory transparency and our progress in making the post-crisis regulatory framework simpler and more efficient," is posted here. Quarles focused primarily on the "framework" the Fed released on October 31 that he said would "better align prudential standards with the risk profile of regulated institutions. These proposals would significantly reduce regulatory compliance requirements for firms in the lowest risk category, including most institutions with between $100 billion and $250 billion in assets. Firms with $250 billion or more in assets, or firms with assets between $100 billion and $250 billion that meet a risk threshold, will face reduced liquidity requirements. The proposals would largely maintain existing requirements for the largest and most complex firms."

Questions

CCAR 'qualitative objection.' In his questions, Chairman Hensarling said that when Quarles last appeared before the committee, he had said the Fed Board had the authority to "jettison the qualitative aspect of CCAR," the Comprehensive Capital Analysis and Review stress tests for banks, but in the Fed's new framework, the qualitative aspect "has only fallen off … [to] the lowest of the four tiers that we now operate under." He said this was disappointing and asked why the quantitative aspect of the test is not sufficient. Quarles said, "We do have the power to jettison, and I believe the time has come for us to move the qualitative objection into our regular supervisory engagement with firms as opposed to a separate process. We've already done that with the smaller firms … I think it's appropriate for us to look at that part of the firms' practices as we look at many of their other practices as part of our general evaluation of the firms' risk management, of their capital planning, and include that in their overall ratings, but not as a separate process."

Stress test models. Hensarling said he and others have advocated for "transparency with respect to the models of the stress test, and … I'm still uncertain about what will be released about these tests … the rule of law works best when you actually know what the rule of law is … I think many people are still unclear about what the Fed intends to share with respect to the stress test." Quarles said that up until now, there has been "limited" transparency about the models the Fed uses to evaluate the performance of banks' portfolios during stress tests. "We have proposed being much more granular about what we reveal about those models, and specifically the loss function with respect to different categories of assets, and what losses we expect to see in response to particular stresses," he said. "Banks will be able to have a better understanding then of how their models compare with at least those loss functions of ours." Quarles said the October 31 framework also says "that we will continue to get more transparent with each iteration of the stress test. So there will be certain models about which more transparency is given in the next cycle, and after that, more transparency about certain other aspects of our models." He said that over the coming year, the Fed will also seek comment on "the design of the scenarios themselves as opposed to the models — that's a more complicated question."

Volcker Rule. Both Hensarling and French Hill (R-AR) asked if Quarles was familiar with a bill (HR 4790), which passed the House with 300+ votes, that would "help simplify [the Dodd-Frank] Volcker [Rule] by unifying under one rulemaking authority and one regulatory authority." Quarles said such a move "would require interagency agreement, but certainly the agencies could agree to operate in that fashion." He told Rep. Hill that "the work right now on simplifying Volcker is proceeding very well. And while it's being pushed by the Fed, all the agencies are participating equally, I think exactly as one would want and expect if the proposed legislation were in effect. So I would think that … at least in the initial circumstance, you could maybe see that happening. I'm not sure how sustainable it would be over different administrations, with many different people sitting in these seats."

Reducing capital for large banks. In her questions, Ranking Member Waters said that despite previous assurances by Quarles that he was not in the job to deregulate banks, "the Fed appears to be deregulating the largest banks anyway." She said both progressive and conservative regulatory experts have criticized several of the Fed's proposals, saying they will "materially reduce bank capital and liquidity reserves for the largest banks," and that Fed Governor Lael Brainard had voted against them, saying "the recent tailoring proposal would reduce high-quality liquid assets held by large banks by about $70 billion." Quarles said he thought such assessments were "off the mark," and that "the various proposals, for example, that affect capital were affected by less than 1 percentage point … The liquidity tailoring that we've proposed just a couple of weeks ago, for example … is an implementation of the instruction from Congress that we 'shall tailor' … It does not affect the largest banks in the system, and it would reduce the overall high-quality liquid assets in the system by 2% to 2.5%. There's still trillions of dollars more liquidity in the system than there was before the crisis. We've added $3 trillion of liquidity, multiples of liquidity than existed before the crisis."

'Pending supervisory actions.' Waters noted that a Fed report last week had listed 795 pending supervisory actions against large banks, most of them related to "shortcomings with the banks' governance and controls, including lack of compliance with laws and regulations … Does this suggest that these megabanks are too large to manage?" Quarles told her that such data should be viewed in context, and that since the financial crisis there has been "very material progress by the banks on their capital and liquidity … Now that that is in a much better place, they are turning their resources to addressing questions of governance, and we've seen those MRAs and MRIAs [Matters Requiring Attention or Immediate Attention] about governance begin to come down. I think we would expect to see them continue to come down at a strong clip given that their resources can now be focused principally on those."

Inter-affiliate margin. In his questions, Blaine Luetkemeyer (R-MO) said itwasimportant that the Fed's inter-affiliate initial margin requirements "make sense and not tie up capital. Firms are required to post margin multiple times on the same transaction." He noted that European and Asian regulators don't have the same initial margin rules. He asked if this requirement could be reduced or eliminated. Quarles agreed that the US is "isolated" in this margin requirement: "It's something we have to look at closely. We're still having discussions at the Federal Reserve, but for me it is a priority to address that question, and I personally share your view … Section 23 of the Federal Reserve Act and Regulation W, which implements it, deal with affiliate transactions and protecting against exposures created by affiliate transactions, and it may well be possible that that framework, which has existed for decades, may be entirely satisfactory and allow us to move into compliance with the rest of the world."

Leverage requirement in stress tests. In her questions, Carolyn Maloney (D-NY) said she is concerned about "any effort to roll back the stress tests," which have been successful, noting that the Fed's October 31 framework "proposed to give regulatory relief to banks that are over $250 billion in assets, the so-called Category III banks … [partly] by scaling back two liquidity rules … what evidence do you have that Category III banks are currently holding too much liquidity?" Quarles told her the Fed's "expectation is that depending on where we finally calibrate that liquidity tailoring, it would be between 2% and 2.5% of the overall liquidity in the system. So I don't think that we have, in any material way, affected that liquidity — there's been a huge increase in liquidity in the system since before the crisis — trillions of dollars. This is a small reduction." When Maloney asked if there would still be a "leverage buffer" in the stress test, Quarles said there would not, "because the stress test is one thing and the leverage requirement is another. The leverage requirement is designed to be a backstop to our risk-based measures … It's just that in the risk-sensitive stress test, the risk measures would be risk measures and the leverage measures would be leverage measures." Maloney said she found that troubling: "The leverage ratio has been the binding capital requirement for all of our largest banks in the past two stress tests. So removing this leverage buffer could significantly weaken the stress tests, in my view."

CECL accounting standard. In his questions, Frank Lucas (R-OK)expressed concern about the Current Expected Credit Loss (CECL) accounting standard issued by the Financial Accounting Standards Board (FASB), which would require banks to record expected losses immediately when they make loans. Banks have urged the FSOC to delay the rule, which will take effect in 2020. Quarles said that for "those firms that are affected by the stress test, CECL could actually be a wash, because to the extent that it means a larger reserve at the outset of the period of stress, then you'll chew through that reserve before you chew through other things in the stress test. And it can be a one-to-one offset."

Community Reinvestment Act (CRA). In his questions, Al Green (D-TX) noted that banks have been getting satisfactory CRA reports, and that the Act "seems to be working fairly well, [so] the question becomes: why would we change it, such that it might be weakened to some extent?" Quarles said implementation of the CRA "has become a little formulaic. Both our supervisors and the banks themselves know that if they do X, Y and Z, they will pass. And X, Y and Z has become just a little unimaginative." Quarles said the law could be made more effective for low- and moderate-income communities "by taking this opportunity to reinvigorate the CRA." He said the movement to update the CRA is "a way to really make the CRA achieve the objectives that were identified in 1977, in a way that is continuing to be relevant in the 21st century, not to weaken it at all."

Foreign banking organizations (FBOs). In questions from Andy Barr (R-KY) and Trey Hollingsworth (R-IN), Quarles said the Fed will propose changes to rules for foreign banks early next year; FBOs were not included in the October 31 framework. Quarles said that while foreign banks deserve to have a "level playing field," they have key differences from US banks in their ability to operate in concert with a global parent. "I don't view it as a one-for-one transposition of, if you have an intermediate holding company of X size, it ought to be treated exactly the same as a domestic holding company of X size in order for there to be a level playing field, because there are those differences," he told Rep. Hollingsworth.

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