Bloomberg News
Bank ratings, examination practices and capital requirements are all poised for reforms under the Federal Reserve’s new chief regulator.
In her first speech since being confirmed as Fed Vice Chair for Supervision, Michelle Bowman outlined an ambitious agenda seeking to overhaul nearly every part of the central bank’s oversight apparatus with an eye toward greater cohesion and a rigid focus on bank finances.
“Conditions constantly evolve in the banking system, and so too must the regulatory and supervisory framework,” Bowman said. “We must be proactive and responsive in the face of emerging risks and ensure that the framework operates in an efficient and effective manner.”
Bowman also called for reducing the emphasis on administrative and procedural shortfalls. She also said supervisors should stop trying to eliminate all risk from the banking system. Instead, she endorsed an approach that encourages responsible risk-taking to ensure banks continue to innovate.
“The goal is to create and maintain a system that supports safe and sound banking practices, and results in the implementation of proper risk management,” she said. “Our goal should not be to prevent banks from failing or even eliminate the risk that they will. Our goal should be to make banks safe to fail, meaning that they can be allowed to fail without threatening to destabilize the rest of the banking system.”
Bowman’s road map, detailed in prepared remarks delivered Friday morning at Georgetown University in Washington, D.C., largely tracks with policy positions she has voiced in various speeches, dissenting statements and other comments on bank regulation from the past several years. It emphasized the importance of “pragmatism” in policymaking, regulatory tailoring and safeguarding against unintended consequences.
Several of her top objectives also align with the broad priorities of Trump administration officials and Republicans in Congress.
Supervisory Ratings
In the early weeks of this year, reputational risk became the poster child for bank supervision run amok, resulting in agency actions and legislation seeking to remove it from examiner guidebooks.
The focus on this particular type of supervisory judgment gave way to a broader push to curtail discretion in the examination process, including calls to remove the management component of the critical CAMELS — capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk — rating system.
Bowman has, in previous remarks, lamented the fact that two-thirds of large banks are deemed to be not well managed in the Fed’s semiannual supervision and regulation report despite the majority being financially sound and well-capitalized.
In her speech Friday, Bowman said examiner judgement is a “legitimate and necessary tool in supervision,” but emphasized that its use should be “grounded in the materiality of the identified issues” and focused squarely on the financial health of the individual bank as well as the broader banking system.
So while the M component is likely to remain in CAMELS rubric, its ability to singlehandedly tank a bank’s rating is poised to be diminished. Bowman said the Fed will soon propose a change to the large financial institution supervisory framework that would set a higher bar for determining that a bank is not well managed.
“This initial change should help address the gap between assessed ratings and material financial risk for those firms subject to this framework,” she said. “We have an obligation to ensure that our supervisory ratings are current, credible, and reflect material financial risk. This promotes effective supervision and ensures that firms are accurately rated based on their underlying financial strength, which should increase the public’s confidence in our assessment of the banking system.”
Because it is the Federal Reserve’s turn to hold the chair set on the Federal Financial Institutions Examination Council — a collaborative policy board that includes heads of all the federal banking agencies as well as a state banking representative — Bowman will be positioned to influence how other examining institutions handle their ratings processes, too.
Bank supervision
Along with renewed emphasis on financial issues and a shift away from procedural citation, Bowman has other structural changes in mind for the Fed’s supervisors.
Bowman said the Fed will now require all members of its large bank examination teams to be certified as commissioned bank examiners. Currently, she said, there is no such requirement so many individuals tasked with overseeing and engaging with banks have not gone through the four-year training and licensing program.
“Regulated entities should be able to expect that all of our examination and supervisory teams have achieved or are working to achieve this level of professional expertise,” she said.
During a question and answer session following her speech, Bowman said one of the benefits of the training program is that it teaches examiners how to effectively communicate with bankers — a skillset that some in the banking industry feel has been lacking.
“It’s not only important to deliver messages about what banks are not doing well, but you also have to be able to deliver messages about what banks are doing well, so you have a balance in your communication and you’re being appropriately moderate in your tone,” she said. “It’s important in my mind that, one, we’re communicating appropriately with banks, and two, that as we’re looking at the largest banks, that our examiners are qualified and have developed an expertise that allows them to have credible findings in their exam reports.”
Bowman also promised to review other supervisory practices around guidance and so-called horizontal reviews.
On guidance, she said agency communication should aim to answer questions and provide clarity to the industry rather than be used as a means for deterring banks from engaging in specific activities. In recent years, she said, supervisory guidance around emerging technologies has only served to stifle bank innovation.
“It’s important that we continue to enable banks to access innovation and we not curtail their ability to engage simply because we don’t understand the technology they would like to engage in,” she said during the Q&A portion. “It’s imperative for regulators not reflexively say ‘No, we need to fully understand the technology or process or services a bank would like to engage in,’ before we say writ large, ‘No you can’t engage in those kinds of activities.'”
Similarly, she said the horizontal review process — through which examiners compare banks to institutions of similar size and focus — can be an effective strategy for understanding specific topics and practices. But, she said, it is important for examiners not to use these reviews to create de facto policies, in which the most stringent bank’s risk management practices become the standard to which others are held.
“Differences in approaches are not indicative of shortcomings, particularly since these can often be explained by distinguishing the underlying activities, scope and scale of operations, and risk tolerance of the firm’s board and management,” Bowman said.
Bank Capital and Basel III
Like her two predecessors, Bowman will also seek to reform the Fed’s capital requirements and implement the international standards known as the Basel III endgame.
As she has in the past, Bowman made the argument that the current regulatory framework was constructed in a piecemeal, haphazard and backward-looking manner, resulting in structures that were designed to address previous episodes of stress — chiefly the collapse of the subprime mortgage market and resulting financial crisis in 2008 — and that often overlap with one another.
“We tend to review individual elements of the capital framework in isolation, without considering whether proposed changes are sensible in the aggregate and contribute to a capital framework in which all components work together effectively,” she said. “While each component is important, the aggregate calibration of requirements is ultimately the most meaningful, and we must examine whether this approach in totality appropriately captures risk.”
To address this, she committed to a full review of the Fed’s various capital requirements, including the annual stress test for large banks, the supplemental leverage ratio, the global systemically important bank and the various standards that fall under the international framework known as Basel III.
Bowman said the Fed will host a conference on capital next month to bring in bankers, academics and “other capital experts” to identify the best way to rethink the framework.
“I welcome the opportunity to consider a broader range of perspectives as we look to the future of capital framework reforms,” she said. “In addition to considering potential changes to leverage ratio requirements and stress testing, the capital conference will also include a discussion of potential reforms to the GSIB surcharge and the Basel III capital requirements.”
