Recent Regulation

Recent Regulations: Federal Reserve’s Risk Tailoring Rules

What was the Financial Crisis? Was it a mortgage bubble that burst the economy? Or risky decisions by investment bankers? Did it result from funding shortfalls in the shadow banking sector? Or was it the outcome of regulatory oversights? Whatever the answer is to this question – and it may well be all of the above – there’s no doubt about who answered. When the economy caught fire, the Federal Reserve, working in concert with the Treasury Department, fought the blaze. Recently, the Federal Reserve’s Board of Governors, faced with a cooling economy instead of an overheated one, approved of rules that alter the post-crisis structure for regulating banks. Under two new rules, a set of banks – representing more than $3 trillion in combined assets – will be subject to tailored regulations based on their size, complexity, and riskiness. For the majority of the Board, the rules balanced the Fed’s goal of reducing banks’ regulatory burdens with the Fed’s ongoing efforts to prevent another crisis. Governor Brainard, the Board’s sole dissenter, insisted that the rules tipped the scales in favor of bank deregulation, an imbalance she deemed premature and perilous. Although Governor Brainard’s dissent suggests that these rules signal a shift in Fed policy, they actually exemplify a continuing trend: the new rules continue the enormous, almost unchecked discretion granted to the Fed to regulate the global banking system before, during, and after the Crisis.

In an Open Board Meeting on October 10, 2019, the Fed’s Board of Governors voted four to one in favor of two rules that revise a number of post-Crisis regulations on banks. The new rules, developed jointly with the Federal Deposit Insurance Corporation and the Comptroller of the Currency (and still pending those agencies’ approval), were not entirely discretionary: in 2018, as part of the Economic Growth, Regulatory Relief and Consumer Protection Act (called the Crapo Act, after Senator Mike Crapo, who leads the Senate Banking Committee), Congress mandated regulatory “tailoring” for banks with assets under $250 billion. But the Crapo Act left most questions about how to tailor for the Fed and other financial regulators to decide. The Fed, in turn, formulated its own priorities based on perceived expectations of Congress and the public. As Chair Powell, in his opening remarks at the October 10 meeting explained, “Congress and the American people rightly expect us to achieve an effective and efficient regulatory regime that keeps our financial system strong and protects our economy, while imposing no more burden than is necessary.”

To realize this end, the new rules adopted by the Fed use size, cross-jurisdictional activity, and a variety of other risk factors to sort all large banks into four groups, subjecting each to different regulations. The largest, most complex, and highest risk banks, like Bank of America, Goldman Sachs, and JP Morgan Chase, face no changes under the rules; they will still be required to undertake annual, public stress tests that show their financial resiliency, provide regulators with so-called “living wills” that show how they will deal with a failure, and keep substantial, high-quality liquid capital on hand in case a crisis occurs. Banks in Category II, including Northern Trust, Deutsche Bank, and Barclays, are large and complex too – they are defined as having at least $700 billion in total assets or $75 billion in cross-jurisdictional activity – and thus remain subject to almost identical rules as in the prior regulatory regime, even if they are formally separated out for the first time.

The biggest changes come for the final two categories. Banks in Category III, like Capital One, HSBC, and Charles Schwab, all defined as having more than $250 billion in total assets or more than $75 billion in non-bank assets, can keep 15% less cash and government bonds on hand to cover their projected cash outflows, need to provide a living will only every six years, and are required to publicly report stress tests every other year instead of annually. Banks in Category IV, including Satander, Fifth Third, and American Express, are still sizeable – they are defined as having between $100 and $250 billion in assets – but they now are never required to publish the results of their stress tests or provide a living will to regulators. In addition, their liquid-capital-on-hand requirements are effectively eliminated.

Governor Brainard, the last remaining Obama appointee on the Board other than Chair Powell, voted against the rules. In her statement of opposition, she emphasized four problems with the tailoring rules, focusing on the reduced standards for banks in Categories III and IV. First, she argued that the reduced regulations applied to banks of exactly the size as those that needed to be acquired during the Financial Crisis. Reducing the liquidity requirements for those banks – requirements that had been put in place only after the Crisis and had yet to be tested by another crash – was risky. Second, she lamented the fact that the rules did not expand regulatory requirements to U.S. branches of foreign banks, which, by virtue of the outsized role of the dollar in the global economy, are among the most active in the U.S. Third, she criticized the expansion of a carve out for capital requirements that was intended for small banks but would now include larger Category III banks. Finally, she noted that the significantly reduced requirements for living wills went well beyond the statutory mandate. She concluded, “I am concerned the rules we are voting on today . . . weaken core safeguards against the vulnerabilities that caused so much damage in the crisis.”

Governor Brainard may be right that the substance of the changes is a significant departure from post-crisis Fed policy, but the Fed’s regulatory process here is of a piece with its longstanding freedom to run the economy as it wants. Under the Federal Reserve Act, the Board of Governors is charged not only with maintaining a stable monetary and credit supply, but also to do so in service of “maximum employment, stable prices, and moderate long-term interest rates.” This broad grant of authority – essentially to keep the economy going – has made the Fed the most important financial regulator in the world. Yet this broad authority has also meant that the Fed rarely faces the same scrutiny in its policymaking as more explicitly political branches would were they to undertake banking reform.

This is not to say that Congress never steps in to regulate. Most prominently, two years after the Crisis peaked, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which created the Consumer Financial Protection Bureau, established the Volcker Rule, and more. But, for all its breadth and ambition, Dodd-Frank purposefully left many key policy questions to be answered by agencies: it required regulators to create 398 new rules for bankers, derivatives traders, and other financial actors, essentially punting policymaking to the administrative state. As Tim Geithner, former President of the New York Fed and Treasury Secretary, recalled in his memoir of the Crisis, “[W]e didn’t want Congress designing the new capital ratios or leverage restrictions or liquidity requirements.” In his view, the risks of regulatory capture and capricious decision making were greater in Congress than at the Fed.

Under Section 165 of Dodd-Frank, Congress granted the Fed’s Board of Governors broad discretion to create “prudential standards” for banks with over $50 billion in assets, which it judged to present unique “risks to the U.S. financial stability.” Congress, amidst a range of other delegations, authorized the Fed to set the amount of money – in the form of cash and government bonds – that these large banks needed to keep on hand, and to annually evaluate banks’ ability to withstand another crash via annual stress tests. Since the passage of Dodd-Frank, the Fed has been creating and revising standards regularly, with little fanfare beyond bankers. For example, in 2014, the Fed finalized a rule that required almost all large banks to keep enough assets on hand to cover thirty days of projected cash outflows, a move intended to prevent another round of government bailouts.

This liquidity rule and many other related rules will be altered to fit the four-category approach adopted by the Fed earlier this month. This tailoring does not mean that another Crisis is bound to come, or that the tailoring approach will be to blame if it does. But, for all President Trump’s efforts to politicize interest rate setting, it’s striking that the regulation of banks remains so far under the radar. The lack of attention allows banks to dominate the decision-making process – for example, foreign banks seem particularly likely to benefit under the new rules. And, for its part, the Fed can fairly say that it is simply carrying out its delegated task: to keep the economy running, however it sees fit. But, now, when the economy is doing relatively well, is exactly the right time to consider whether this is how we want banking policy to work. Otherwise, when the next crisis comes, there’ll only be the Fed to turn to for answers.