Recent volatility in the banking sector – triggered by the high-profile failure of three large financial institutions in the first half of the year – is sure to cause banking regulators to re-evaluate the current regulatory framework as well as spark more assertive supervision and enforcement activity. Specifically, the Board of Governors of the Federal Reserve System (the Fed) will likely look to roll back many of the prior “tailoring” rules that were intended to ease the regulatory burdens on some financial institutions.
In 2019, Congress passed the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA), which amended the Dodd Frank Act by raising the $50 billion minimum asset threshold for general application of enhanced prudential standards (EPS) to bank holding companies with $250 billion in total assets. Following passage of EGRRCPA, the Fed revised its framework for supervision and regulation, maintaining EPS applicable to the eight largest, systemically important banks (also known as G-SIBs) but tailoring or relaxing requirements for other large banks.
Following the high-profile bank failures in 2023, the Fed is surely going to revisit its tailoring framework to impose more stringent supervision requirements on other large, non-G-SIB banks. Indeed, in the Fed’s April 2023 review of its supervision and regulation of Silicon Valley Bank (SVB), the Fed’s Vice Chair for Supervision, Michael S. Barr, publicly called for a re-evaluation of the tailoring framework and rules. Specifically, Vice Chair Barr called on the Fed and other banking agencies to evaluate regulatory changes to existing liquidity, capital and stress testing rules.
Liquidity risk. The Fed will likely re-evaluate and propose new rules relating to liquidity risk, starting with the risks of uninsured deposits. The rapid mobility of uninsured deposits featured prominently in the Fed’s review of its supervision and regulation of SVB. Before its collapse, SVB experienced an unprecedented $40 billion in deposit outflows in a single day with $100 billion expected the following day. The Fed and other banking regulators will thus examine and consider changes to liquidity requirements applying to large banks to better capture the liquidity risk of a firm’s uninsured deposit base. Similarly, banking agencies will likely re-examine the treatment of held to maturity securities in standardized liquidity rules, likely applying standardized liquidity requirements to a broader set of financial institutions than under current rules.
Capital. Federal banking agencies have already taken some steps to revise current capital requirements for large, non-GSIB institutions. The Fed’s April 2023 review of its supervision of SVB observed that under the pre-2019 regulatory regime, SVB would have been required to recognize unrealized gains and losses on its available for sale (AFS) securities portfolio in its regulatory capital (by including the unrealized losses on its AFS securities portfolio). And, in late July, the Fed and other federal banking agencies issued a Notice of Proposed Rulemaking to implement the Basel III capital rule. Under the proposal, unrealized losses on AFS securities would flow through regulatory capital for all banks with more than $100 billion in assets. This means that these banks, in order to maintain their capital levels, would need to retain or raise more capital as these unrealized losses occur.
Similarly, on August 29, 2023, the Fed and the FDIC issued a proposed rule for comment that would require large banks with more than $100 billion in assets to issue and maintain minimum amounts of long-term debt (LTD) that could be used to absorb losses in the event of bank failures. Specifically, the proposed rule would require covered entities to maintain a minimum amount of eligible LTD equal to the greater of 6 percent of risk weighted assets, 3.5 percent of average total consolidated assets, and 2.5 percent of total leverage exposure if the covered institutions are subject to the supplementary leverage ratio rule. In issuing the proposed rule, the Fed and FDIC noted that the recent bank failures “have highlighted the risks posed by the disorderly resolution of certain large banking organizations” which were, in part, “prompted [by] significant withdrawals [of] uninsured depositors at unprecedented speeds.” The Fed and the FDIC contend the proposed rule will “support financial stability by improving the resiliency and resolvability of large banking organizations.”
Stress testing. As Fed Vice Chair Barr noted, “[s]tress testing is a key supervisory tool.” However, as a result of tailoring rule of 2019 and other rule makings, many firms were excepted from some stress testing requirements or granted more lenient timelines to conduct them. Vice Chair Barr has thus called on the Fed to revisit the scope of stress testing to reach more banks with $100 billion or more in assets.
Supervision and enforcement. Any adjustments to the Fed’s rules are, of course, subject to notice and comment rulemaking, thus any proposed regulatory changes would not be effective for some time. However, in the meantime, the Fed is likely to increase the intensity of its supervision of large banks, which does not require regulatory changes. In fact, the Fed’s May 2023 Supervision and Regulation Report noted that bank examiners have already increased their scrutiny and monitoring of liquidity risk management, deposit and funding source trends, as well as capital and resolution planning at large financial institutions. Similarly, FDIC Chairman Martin Gruenberg recently stated that the “FDIC is reviewing whether its supervisory instructions [to bank examiners] on funding concentrations” and other matters should be revised to increase scrutiny and better capture current risks.
Moreover, Fed Vice Chair Barr has called on bank examiners to focus “on inherent risk, and . . . challenge bankers with a precautionary perspective.” Therefore, even in the absence of regulatory changes, bank examiners and enforcement staff are likely to be more assertive than in the recent past. Bank examiners are likely to increasingly challenge management and boards to address risks and supervisory findings more quickly. This could result in supervisory criticisms being escalated to non-public and/or public enforcement actions, such as consent orders, more quickly than in the recent past. Similarly, banks should expect less time to address concerns raised in examination as “matters requiring attention” or MRAs before they are elevated to an enforcement action.
Takeaways: Greater regulation, higher costs
Recent events have caused the winds of regulatory change to blow in one direction. In response to recent bank failures, the Fed and other banking regulators will surely seek (and have already sought) to impose greater liquidity, capital and other requirements on banks with $100 billion or more in assets.
These changes will come with higher operating and compliance costs. Indeed, commenting on the proposed minimum LTD rule, Fed Governor Michelle Bowman noted that the proposed rule would “impose significant costs on firms . . . and may be duplicative of or overlapping with other pending regulatory proposals.” She noted that the proposed minimum LTD and Basel III capital rules “would not operate independently of each other [as] increases in risk-based capital requirements would also increase long-term debt requirements,” and she warned that the combined effect of these rules “could significantly alter how banks are funded, the activities in which they engage, the products they offer, and the markets they serve.”
These and other regulatory changes, and their associated costs, will be accompanied by more intense or assertive supervision of liquidity, capital, and other risk areas by bank examiners. Notwithstanding the Interagency Statement Clarifying the Role of Supervisory Guidance (effective May 10, 2021), large financial institutions can expect bank examiners to rely heavily on non-binding supervisory guidance in assessing safety and soundness “violations” and deficiencies. In other words, bank examiners’ burden of proof to support a given supervisory conclusion is sure to decrease, and bank examiners are likely to assertively “challenge bankers” and bank boards, as Fed Vice Chair Barr suggested.
Although the Fed has already started down the path of new rulemaking and assertive supervision, large financial institutions can expect this trend to continue.