Monday, August 7, 2017

Risk Management Still at the Heart of Financial Regulation

Fed Official Urges a Tiered Risk-Based Calibration of Post-Crisis Reforms

In an August 2, 2017 address, President and CEO of the Federal Reserve Bank of Cleveland Loretta J. Mester advocated a fresh risk assessment to recalibrate financial regulations and right-size them to ease the burden on smaller banks. Ms. Mester proposed "tiering of oversight by risk,” thereby relieving community banks from much of the regulation intended for larger banks whose activities present different and larger risks to the greater financial system than those of smaller institutions. 


According to Mester, “[c]ommunity banks generally don’t impose costs on the rest of the financial system or create the kinds of contagion that can put the entire financial system at risk, so their oversight should differ from that of systemically important institutions.” 


This does not mean exempting smaller banks from scrutiny, however. 


"At the same time, as the savings and loan crisis in the 1980s and the commercial real estate crisis in the late 1980s and early 1990s remind us, when many smaller institutions get in trouble at the same time, this can also harm the economy. So maintaining the safety and soundness of smaller institutions cannot be neglected. It’s a matter of aligning oversight with potential risk.”


Ms. Mester admits that tiering of regulation based on risk profiles would add more complexity to an already complex body of regulation. That said, she says the added initial complexity is necessary; but, in the long run would yield simpler regulations while enhancing safety, soundness, and resiliency. 


"This tiering of oversight by risk adds some complexity to the financial system’s regulatory framework. But the U.S. financial system is quite complex and ever-changing, with various types of banks and nonbank providers of financial services. So some complexity is to be expected. To paraphrase H.L. Mencken: “For every complex problem there is a solution that is clear, simple, and wrong.” That said, it’s important that the regulatory framework avoid excessive complexity, which can complicate supervision, risk monitoring, compliance, and enforcement. Too much complexity can make it harder for banks to understand the standards they are being asked to meet, and harder for regulators to assess compliance and overall risk. Better aligning our regulation and supervision with the risks imposed could allow simplifications without sacrificing safety, soundness, and resiliency.”


The Volcker Rule is a perfect example of where this risk-based tiering of regulation could be applied to great effect, Ms. Mester said. 


"Dodd-Frank generally limits banks from engaging in proprietary trading of financial instruments and investing in hedge funds and private equity funds. But the rule is quite complex. Given that community banks are not likely to participate in such activities, there doesn’t appear to be much to gain from having them maintain a compliance program. So I support exempting community banks from the Volcker rule.”


Ms. Mester listed some ways in which regulators are already hard at work trying to simplify some of the post-crisis banking reforms and reduce burdens on smaller banks. A recently concluded decennial review of banking regulations identified and eliminated 78 out-of-date guidance letters. The review also resulted in the reduction and simplification of the data-reporting requirements for small community banks, resulting in a shorter Call Report. In addition, exam frequency has been reduced for a large set of institutions. 


"Now, 83 percent of all insured depository institutions qualify to be examined every 18 months rather than every 12 months, as a result of a provision in the Fixing America’s Surface Transportation (FAST) Act that raised the asset threshold from $500 million to $1 billion."


Mr. Mester also said that regulators were working on other ways of "aligning the degree of prudential oversight with risk” not just for community banks, but larger banks as well. Among the expected outcomes of this realignment is a simplified capital framework for community banks and an increase in the thresholds for bank stress testing, capital planning, living will, and other enhanced prudential requirements for larger banks. 


"The agencies are also working to develop a simplified capital framework for community bank organizations.11 For large banks, the combination of risk-based capital requirements, a leverage ratio requirement as a back stop, liquidity requirements, and annual stress testing is appropriate. But one has to ask whether the compliance costs faced by small community banks in adhering to a complicated risk-based capital regime outweigh the benefits in terms of safety, soundness, and financial system resiliency, compared to an alternative regime comprising a leverage ratio requirement based on high-quality capital, combined perhaps with a simplified risk-weighted capital requirement.


The guiding principle of aligning the degree of prudential oversight with risk applies not only to community banks but also to larger banks. Dodd-Frank requires that banks with assets between $10 billion and $50 billion be subject to company-run stress tests and that banks with assets of $50 billion or more be subject to annual supervisor-administered stress tests, capital planning, living will, and other enhanced prudential requirements. I support some increase in the thresholds but also believe that the combination of these requirements at systemically important banks has led to a stronger and more resilient financial system and should be maintained.”


Some of the changes to the regulatory regime advocated by Ms. Mester will require legislation. In the meantime, however, Ms. Mester says the Fed is committed to improving its responsiveness to community banks as well as "clarifying supervisors’ expectations with respect to consumer compliance and community development rules.”  Also, the Fed has committed to "undertaking a comprehensive review of its safety and soundness examination framework for community banks, and developing analytical tools so that we can better focus our supervisory efforts on the highest risks while reducing the regulatory burden on low-risk community banks.”


The full text of Ms. Mester’s address is available via: