Governor Bowman Warns Against Unresponsive and Irresponsible Supervision
Today in remarks delivered in Austria Federal Reserve Governor Bowman spoke about “responsive and responsible bank regulation and supervision.”
Governor Bowman made clear in the course of her remarks that this speech “should not be interpreted as a categorical rejection of reform efforts,” and indeed as discussed below the speech identifies several areas in which supervision for large banks could be improved.
At the same time, Governor Bowman’s remarks also include several implicit criticisms of the way the U.S. supervisory and regulatory approach is trending, as well as a few explicit ones. In certain places, there are areas of sharp divergence from the remarks delivered last week by FDIC Chair Gruenberg and Federal Reserve Board Vice Chair for Supervision Barr.
Note, of course, that the remarks bear the typical disclaimer that they are only the views of Governor Bowman and not necessarily those of any other Governor.
Direct Criticism of the VCS Barr-led SVB Review
In a speech last month, Governor Bowman called for an independent third party to prepare a report on the Federal Reserve’s supervision of SVB, as a way to “help to eliminate the doubts that may naturally accompany any self-assessment prepared and reviewed by a single member of the Board of Governors.”
Today’s remarks from Governor Bowman are even more direct about the potential shortcomings of the existing report. 1
Much of the work done to date has been helpful and has brought to light some uncomfortable realities about the lead-up to the bank failures.
But much of this work was prepared internally, by Federal Reserve supervision staff, relying on a limited number of unattributed source interviews, and completed on an expedited timeframe with a limited scope.
Although the report was published as a report of the Board of Governors, it was the product of one Board Member, and was not reviewed by the other members of the Board prior to its publication.
Troublingly, other Board members were afforded no ability to contribute to the report’s content.
There is a genuine question whether these efforts provide a sufficient accounting of what occurred. A supplemental, independent review would help overcome the limitations of scope and timing of these initial efforts, and address concerns about the impartiality and independence of the reviews.
Governor Bowman believes that without an independent review, "[m]isperceptions and misunderstandings about the root causes and related issues could result in changes that are not unnecessary but result in real harm to banks and their customers, the financial system, and to the broader economy.”
The Substance of, and Process For, a New Capital Rules Proposal
Consistent with remarks made by Chair Powell before Congress this week, Governor Bowman committed to approaching any capital rules proposal with an open mind, while recognizing the tradeoffs between increased resiliency and potential increases in cost of credit.
Governor Bowman then went on to flag a few reservations, or at least considerations, with respect to where the proposal may be heading.
Market Risk. One key feature of the yet-to-be-implemented Basel rules involves changes to capital requirements for market risk as a result of the Basel Committee’s fundamental review of the trading book. Governor Bowman worries that “[o]verregulation in trading book capital requirements” could adversely affect the liquidity of debt and equity markets, and increase the cost of market making.
As is a typical tactic (sometimes even a justified one) in critiquing regulatory proposals, Governor Bowman here focused on an example of what the rule would mean for communities, rather than simply what it would mean for banks. “We cannot understate the potential impacts. Communities often fund local infrastructure projects by issuing municipal bonds in public debt markets. If this funding source evaporates, or becomes more expensive, that can have severe consequences for these communities.”
Gold Plating. Governor Bowman also commented on the gold-plating of certain Basel standards as implemented in the U.S., some of which has been driven by the agencies and some of which has been a result of Congressional directives. Governor Bowman says she does not point out this gold-plating by way of “indictment of the robust capital standards” in the United States, but rather as means of establishing the baseline for the impact of future capital changes.
Disfavoring Certain Activities. Governor Bowman’s remarks reiterate that the Board and other U.S. banking regulators “are not and should not be in the business of making capital allocation decisions regarding bank lending.” This is consistent with what Chair Powell and all the other Federal Reserve Board Governors (and Governors-to-be) have said, including in testimony before Congress last week.
Governor Bowman goes on, though, to flag a related concern: “In the same way, bank regulators should also not direct bank business strategy about the products and services offered by establishing capital requirements that are disproportionate to risk.”
I am not sure whether this is a reference to hinted at but not yet internationally adopted future Basel standards,2 or whether this is a concern about specific provisions of the U.S. proposal coming this summer.3
Finally, aside from the substance of what the new rules say, Governor Bowman made two calls related to the process for adopting them.
First, Governor Bowman says the comment period should be “at least 120 days.”4 Second, Governor Bowman believes the significance of the proposal calls for a public, open Board meeting to discuss and debate it. Governor Bowman notes that this had been the Board’s practice, but is something it has “largely departed” from since the COVID-19 pandemic.
Is Pushing Activity to the Shadow Banking System a Valid Concern?
Governor Bowman’s speech also acknowledges the oft-cited concern that heightened capital requirements could have the effect of advantaging non-bank competitors which are not subject to the same regulation.
Rising bank capital requirements may exacerbate the competitive dynamics that result in advantages to non-bank competitors and push additional financial activity out of the regulated banking system. This shift—while possibly leaving a stronger and more resilient banking system—could create a financial system in which banks simply can’t compete in a cost-effective manner. […]
Even the resiliency of a smaller, safer banking system could prove illusory when we look deeper into the connections between banks and non-banks, for example, with subscription lines of credit supporting the private credit industry, and the indirect bank-financing of non-bank mortgage lending activities through traditional bank credit lines.
This is all pretty standard commentary, but the reason I highlight it here is because it is an argument FDIC Chair Gruenberg addressed fairly dismissively in the Q&A after his remarks at the Peterson Institute last Thursday.
Adam S. Posen:
Another development, particularly in recent years has been the shift of various forms of lending including, for example, commercial real estate, to nonbank financial institutions - what some of us used to call shadow banks. A different line of argument against stricter capital and liquidity requirements is that this will further drive activity — lending activity of various sorts — outside the regulated, supervised banking system to these non- [or] less- regulated shadow banks. What is the evidence in your view since Dodd-Frank and the first round of Basel III on this question? And also, again just to provoke, isn’t part of the point to get the riskier stuff out of the regulated banking system?Chair Gruenberg:
I always have trouble with the logic of saying, “We shouldn’t have appropriate capital standards to strengthen the resilience of the banking system because then assets might flow out of the banking system.” The logic there seems to be to have more vulnerable banks to avoid that happening. The logic of that, given our experience, is hard for me understand. I think we need to set appropriate capital standards to the risk of the banking institutions.Nonbank financial institution risk is a big ticket item. It’s a big ticket item in the United states. It’s a big ticket item globally. It has been — it is — a subject of attention by the Financial Stability Oversight Council here in the United States, it’s been a priority of the Financial Stability Board internationally. So it’s a key risk area that requires great attention, but it requires great attention on its own terms, and we need to consider means of addressing it. But this should not in a sense be a zero sum game with the banking system. I don’t think we want to compromise appropriate capital requirements for the banks because of that concern.
This response, too, is pretty standard, and I would expect the same back-and-forth to occur many, many times in the months after which the rules are proposed.
Avoiding a Barbell-Shaped Banking System
I am not sure if this was a conscious choice, but Governor Bowman’s speech picks up on the same “barbell” concerns as voiced by a few Senators with Chair Powell and Governors Cook and Jefferson last week.
Our goal should not be to create a “barbell” of banking institutions based on size, with a small number of too-big-to-fail banks at the large end of the spectrum, and some smaller community banks at the low end.
Governor Bowman at several points in her remarks suggests this barbell-shaped banking system is a possible unintended result of an inappropriate move away from regulatory tailoring.
“Eliminating banking standards tailored for these characteristics would create intense pressure on the smaller end of that spectrum to consolidate, as smaller banks struggle to adapt to regulation ill-suited for their size or complexity, applying instead regulations designed for a G-SIB.”
“Under the weight of overly burdensome or redundant regulation, the business models of some banks may simply cease to be viable. Many banks would be unable to operate under the weight of increased compliance costs.”
“The consequences of excessive and overlapping regulations will inevitably be forced consolidation and reduced consumer choice, especially in underserved banking markets. Even in the absence of consolidation, banks always face choices in responding to regulation, and may pare back on lending to small businesses, or forfeit their banking charter and choose to operate instead within the nonbank sector.”
“If we were to apply some of the same heightened standards for banks with $50 billion or $100 billion in assets as we have for banks with trillions of dollars in assets, this inevitably would create pressure to merge to create economies of scale to lessen the cost of regulatory compliance, resulting in further bank consolidation.”
That last comment in particular stuck out to me because the regulators have suggested that, even in the most expansive scenario, the lowest the new capital rules would reach is firms with $100 billion in assets. The one recent development I can think of where the application of a lower threshold has been signaled is the FDIC’s recently announced agenda item concerning IDI resolution plans, which suggests they are keen to reimpose some sort of requirement on $50 billion asset and larger banks.5
A “Supervisory Void” in the Approach to Novel Activities
In Governor Bowman’s view the current approach to banking-as-a service, digital assets, and other novel activities has left banks in a “supervisory void.”
While there have been some efforts to provide guidance, there remains substantial uncertainty about the permissibility of and supervisory expectations for these activities, including banking as a service, digital assets, and other novel activities. This leaves banks in the perilous position of relying on general but non-binding statements by policymakers only to be criticized at some point in the future. The absence of a clear regulatory and supervisory approach creates the risk that regulators may determine novel activities are impermissible or impose new requirements and expectations on these activities after the fact and, for some first movers, after significant investment.
Compare these remarks to those of Vice Chair for Supervision Barr back in March:
[T]he Federal Reserve had recently decided to establish a dedicated novel activity supervisory group, with a team of experts focused on risks of novel activities, which should help improve oversight of banks like SVB in the future.
These ideas are not necessarily in tension, of course. Adopting a clear regulatory and supervisory approach first requires identifying and understanding the risks that this regulatory and supervisory approach are meant to address. But I think the point of Governor Bowman’s remarks is that while it is nice to have a team working on identifying risks of novel activities, if that does not result in a clear explanation of how (if at all) banks can go about engaging in such activities while managing the associated risks, then this is going to result in a less-than-ideal void like the one Governor Bowman describes.
A potential example of this is the banking agencies’ crypto-asset policy sprint, which as described in a November 2021 joint agency statement said that the agencies intended throughout the course of 2022 to provide more concrete guidance on various activities.
Throughout 2022, the agencies plan to provide greater clarity on whether certain activities related to crypto-assets conducted by banking organizations are legally permissible, and expectations for safety and soundness, consumer protection, and compliance with existing laws and regulations related to:
Crypto-asset safekeeping and traditional custody services.
Ancillary custody services.
Facilitation of customer purchases and sales of crypto-assets.
Loans collateralized by crypto-assets.
Issuance and distribution of stablecoins.
Activities involving the holding of crypto-assets on balance sheet.
In the end, the banking regulators wound up not doing this, although their views on crpyto-assets found expression in other ways.
To be clear, my own personal view is that the benefits of, and use cases for, crypto are usually and at best dramatically overstated, so I am certainly not claiming that banks were thisclose to revolutionizing financial services, if only they had been provided with more detailed guidance.
Still, if you are going to make trust and transparency in the banking system one of your key themes, doing what you say you are going to do should be a key element of that.
Appropriate Areas of Focus
As noted at the outset of this post, though Governor Bowman’s speech includes some fairly pointed comments, the speech is meant to be constructive, and not a categorical rejection of any reforms. To that end, throughout the remarks Governor Bowman notes several areas of potential improvement:
“a focus on the most relevant banking risks with a demonstrated nexus to bank stability and safety and soundness,” including “a renewed examination focus on core banking risks like liquidity and interest rate risk”;
“a careful review of liquidity requirements and expectations”;
changes to “the Fed’s emergency authorities and liquidity tools”;
changes to “the resolution, auction and insurance processes of” the FDIC;
“more effective communication among regulators and within the Federal Reserve System and Board’s supervisory program”; and
“greater transparency in supervisory expectations with enforceable and timely consequences when expectations are not met.”
The most interesting comment in the speech, though, may be the one at the very end, saying that improvements in the supervision of large banks may be “particularly” necessary for “those in Category IV of the U.S. tailoring framework.” Governor Bowman does not go into further specifics but this is a sign, to the extent further signs were still needed, that banks with $100 billion in assets should prepare for increased regulation, even if there are still differences of opinion between the banking regulators as to just how much new regulation is required.
Thanks for reading! Thoughts on this post are welcome at bankregblog@gmail.com, including in particular thoughts on anything significant from the text or subtext of Governor Bowman’s remarks you believe I have missed or misinterpreted.
*This post was updated on Sunday evening to add a link to Governor Bowman’s remarks, which I inadvertently omitted.
I have added paragraph breaks and emphasis in bold.
Among other planned actions on climate-related financial risk, the Basel Committee’s 2023-24 work programme says the Committee “will undertake analytical work to assess the materiality of gaps in the existing Basel framework. Building on this work, the Committee will consider whether potential regulatory measures to address climate-related financial risks are needed.”
A few industry groups have flagged concerns about what the FRTB rules could mean for the treatment of carbon credit trading, but (1) this is an aspect of the FRTB changes I am not sure I fully understand and (2) as noted above in any case Governor Bowman could be talking about something completely different.
Anyways, here are the trade groups.
And as new markets and products emerge, they’re also going to be shaped by the FRTB. For example, a recent study showed that the reform package could negatively impact the emerging carbon and credit trading markets by imposing a more punitive risk charge on carbon certificates, and more generally penalizing banks for carrying these positions on their books.
The FRTB would result in higher capital charges for carbon trading under the standardized approach to market risk, which could impair the ability of banks to act as intermediaries in the emissions trading system market globally, hampering a key tool for policy-makers to ensure a cost-effective transition to a carbon-neutral economy.
This would be roughly in keeping with precedent. In 2012 the capital rules were proposed on June 7, with comments initially due by September 7. The agencies later extended the comment period to October 22.
The FDIC’s agenda entry suggests that full-scale resolution plans will be required for $100 billion banks, while banks with between $50-$100 billion in total assets would need to make unspecified “informational” filings.