The Federal Reserve’s Rollback of Bank Regulation: Boon or Bust?
The Federal Reserve has decided to lift a portion of its regulatory controls that were implemented following the 2008 recession. Specifically, the Reserve wishes to eliminate its “stress test” exams that give pass-or-fail grades to the nation’s largest banks such as JPMorgan Chase & Co. and Goldman Sachs Group Inc. Grades on the qualitative section of the test would be eradicated for U.S. firms that have taken said exam for at least four years and passed in the most recent year. Theoretically, if a bank passes the Fed’s evaluation in 2018, it could fail in 2019 and still avoid a public failing grade. Foreign firms will be eligible for exemption from pass-or-fail grades as of 2020, since many of them have only been assessed for two years. In addition to providing quantitative financials the exam requires a subjective review of a bank’s risk assessment, internal data, and the role its board of directors portrays in managing operations. According to the Dodd-Frank Act’s Comprehensive Capital Analysis and Review (CCAR), the Fed has been required to conduct annual supervisory stress tests that project complex firms’ net income, balance sheets, regulatory capital ratios, post-stress capital levels, and risk-weighted assets (RWAs). Additionally, banks must submit which method of capital deployment they plan to utilize such as the repurchasing of stock or raising of their dividends. As stated by the Federal Reserve, this system aims to provide company leaders and board of directors, supervisors, and the general public with financial forecasts that “gauge the potential effect of stressful conditions on the ability of these large banking organizations to absorb losses, while meeting obligations to creditors and other counterparties and continuing to lend.”
Interestingly, last June, Deutsche Bank AG was the only institution, out of the 18 domestic and foreign banks that were examined, to fail the qualitative section of the stress test. The Fed reported “widespread and critical deficiencies across the firm’s capital-planning practices,” citing that the German lender had an inadequate system of risk-management controls and lacked sufficient capability to project revenues and losses for core business lines. Such operational and managerial inefficiencies provoked concern that Deutsche’s U.S. branch was unable to effectively forecast its capital needs, considering that the evaluated unit was primarily comprised of the bank’s domestic operations and trading platform. 2018 marked the first year that the results of Deutsche Bank, as well as other foreign banks that were tested, were made public. According to The Wall Street Journal, the dissemination of the bank’s pass-or-fail grades functions as a sort of public humiliation tactic that is meant to shame these institutions into accepting accountability and restructuring regulatory controls.
Federal officials have defended the financial stability of large domestic banks, assuring that in the wake of the 2008 crisis, the institutions have rectified internal weaknesses in risk-management and have become increasingly safer. In fact, a panel of federal regulators has so much faith in big banks’ solvency that it has suggested tightening supervisory standards for non-bank financial firms, such as those involved in asset management and the insurance industry. Treasury Secretary Steven Mnuchin, leader of the Financial Stability Oversight Council, claims that stricter supervision would appraise risky endeavors across financial markets as a whole rather than concentrate on specific non-banking firms. Easing stress test exams would diminish the Fed’s ability to surprise market makers and bankers with negative news about U.S. firms. For instance, in 2014, the unanticipated reveal of Citigroup Inc.’s stress test failure put the fate of the banking titan, which operates in over 100 countries, in the hands of the Federal Reserve. Fed officials explained that if Citigroup wishes to maintain its status as a global banking superpower, it “must prove it can manage such a sprawling institution without posing systemic risk.”
While executives of these big banks argue that federal government overreach is excessive and forces them to cede an undue amount of control to the Reserve, the central bank’s oversight ensures that these organizations do not grow “too big to fail” and produce the same conditions that led to the 2008 financial collapse. Communication of banks’ pass-or-fail grades to the market upholds a level of transparency and culpability that is crucial in preventing history from repeating itself. Congress, in 2008, spent $700 billion bailing out big banks, since their failure would have resulted in catastrophe for the nation’s entire economic system. During this time, banks were deemed “systemically important” if they possessed at least $50 billion in total assets, resulting in a list of 44 banks. As of May 2018, however, Congress passed legislation that rolls back fundamental elements of the 2010 Dodd-Frank Act, including which banks are subject to additional scrutiny due to significant asset holdings. Now, banks with fewer than $250 billion in assets are liberated from strict federal oversight, signifying a dilution of Obama-era policies governing the United States’ banking system. Supporters claim that much of the Dodd-Frank legislation was burdensome, bridling small and medium-sized banks that were not responsible for the financial collapse. Yet, passage of these changes to the Dodd-Frank Act frees sizable banks from strict federal oversight, such as Barclays, American Express, and Credit Suisse. Although the Federal Reserve defends that big banks have amended capital planning and risk-management practices, perhaps the aggregate effects of slackening bank oversight may incite a financial meltdown similar to that of 2008.
By the same token, last month, the Federal Reserve stated that it will further inform banks of the processes it uses to gauge their ability to meet minimum capital requirements during periods of financial distress. Bank CEOs have contested that failing grades on the qualitative portion of the exam are completely arbitrary and partial, serving as a punitive measure to send a message to big banks. Tests are subjective and the areas of assessment are not specifically understood. By focusing on the numbers-based section of the stress tests, banks can better prepare themselves for evaluation. Dennis Kelleher, President and CEO of Better Markets, laments that “by providing more transparency to the banks in response to their complaints while reducing the transparency to the public risks snatching defeat from the jaws of victory in the Fed’s stress test regime.” Bank executives are still pushing for further changes, such as having the exams conducted every other year as opposed to annually. In fact, James Gorman, the CEO of Morgan Stanley, claims that the stress tests will be more valuable if executed over an extended time frame.
While the pass-or-fail grade system will be abolished, the Fed will continue to privately assess firms’ performance on the qualitative portion of the exam. The central bank assures that significant transgressions merit reveal to the public. Moreover, a firm could fail an independent, quantitative assessment if it does not meet Basel III leverage and capital requirements during a period of financial stress. Although regulations have not been entirely dismantled, it appears that the Fed is yielding to the demands of big banks. Only time will tell if the central bank’s watering down of supervision will lead to another financial crisis.
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