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Senate Banking Committee Hearing with Federal Reserve Vice Chair Quarles

Senate Banking Committee

“Semi-Annual Testimony on the Federal Reserve’s
Supervision and Regulation of the Financial System”

Thursday, April 19, 2018

Key Topics & Takeaways

  • Prudential Regulation: A number of senators asked about the systemically important financial institution (SIFI) designation process, which Quarles explained he was supportive of attempts to tailor regulations. Senators also asked about the Federal Reserve’s proposed changes to the enhanced supplemental leverage ratio (eSLR). Quarles explained that when leverage-based capital measures becomes the binding capital provision, institutions have an incentive to take more risks than they otherwise would.
  • 2155: A number of senators asked about the effects of S. 2155, the Economic Growth, Regulatory Relief, and Consumer Protection Act, to which Quarles replied that sosome changes to regulations will result in improved compliance, lower costs, and a greater ability to achieve the objectives of the underlying regulations.
  • Volcker Rule: Asked to discuss the consequences of having five different regulators enforcing the rule, Quarles acknowledged both the logistical consequences and logic to having five regulators enforcing the rule, as they each have supervisory authority over entities that are affected. He noted that cooperation from other regulators to revise the rule has been very productive.

Witness

Opening Statements

Chairman Mike Crapo (R-Idaho), Senate Banking Committee

In his opening statement, Crapo applauded Quarles on his good work so far and urged Congress to confirm him for his full term on the board as soon as possible. He said that he has been encouraged by statements made by both Powell and Quarles that there is a need to revisit some of the Federal Reserve’s regulations. In particular, he said that he agrees with the overarching objectives of Quarles’ agenda, namely efficiency, transparency, and simplicity of regulation. Crapo then stated that he hopes S.2155, the Economic Growth, Regulatory Relief and Consumer Protection Act makes it to the President’s desk soon. He said that he is looking forward to working with regulators to ensure that their interpretations are consistent with the intent of Congress.

Ranking Member Sherrod Brown (D-Ohio), Senate Banking Committee

In his opening statement, Brown discussed how the financial crisis negatively affected those in his home state of Ohio. He said that the Fed missed the crisis, describing how it had the power to reign in predatory mortgage lending, the power to stop banks from operating with too much leverage, and the power to hold bank executives accountable, but did not do any of these things. Because the Fed neglected its mission, Congress had to pass the Dodd-Frank Act the next year. Brown said that now with legislation coming from this Congress, policymakers are in the process of unraveling many necessary regulations. He continued that when times are good, policymakers, lawmakers, and regulators can be lulled into a false sense of security if they are not vigilant. Brown then stated that when big banks are flush with profits, as they are now, policymakers should be preparing for rough times ahead. Instead, Washington is repeating a failed pattern of boom and bust. He concluded that when things go bad once again, executives will get golden parachutes whereas workers, retirees and consumers will be left “holding the bag.”

Testimony

The Honorable Randal Quarles, Vice Chairman for Supervision, Board of Governors of the Federal Reserve System

In his testimony, Quarles discussed the progress the Fed has made post-financial crisis in creating stronger supervisory programs for most systemically important financial institutions (SIFIs), leading to a more resilient financial system. He noted that the public is not only interested in the safety and soundness of the financial system, but also in its efficiency. Regarding more efficient regulatory measures, Quarles explained that last week the Fed and Office of the Comptroller of the Currency (OCC) proposed recalibrating the enhanced supplemental leverage ratio (eSLR), which is applicable to the global systemically important banks (G-SIBs), and last year’s elimination of qualitative objections to the Comprehensive Capital Analysis and Review (CCAR) for those smaller institutions that pose less risk.

Quarles then pivoted to Congressional attempts to tailor regulations and noted the importance of matching regulations to the institution being regulated, giving the example of calibrating liquidity coverage ratio (LCR) requirements differently for non-G-SIBs and G-SIBs, and improving the efficiency of living will requirements. He continued that the Fed is working with the other federal financial regulators to tailor the implementation of the Volcker Rule to ensure institutions that lack trading activities are not burdened by the rule and concluded that the adoption of post-crisis reforms have strengthened the Federal Reserve’s regulatory framework.

Question & Answer

Prudential Regulation

Brown noted that the Federal Deposit Insurance Corporation (FDIC) recently dissented from the Federal Reserve’s proposed changes to the enhanced supplemental leverage ratio (eSLR). Which would allow the eight largest banks to “drain away” $120 billion in capital, noting that one of the Federal Reserve Governors also voted “no” on the proposal. Quarles responded that when eSLR or any leverage-based capital measure becomes the binding capital provision, the institution has an incentive to take more risks than it otherwise would because it will still incur the same capital costs, saying in the judgement of the majority of regulators, it was important to remove this “perverse incentive” quickly. Senator Bob Corker (R-Tenn.) also asked about the eSLR, inquiring if the eSLR provisions in Section 402 of S.2155 complicates the work of the Federal Reserve. Quarles said that the solution in the bill is one avenue, but that a broader solution may be required to recalibrate eSLR.

Senator Patrick Toomey (R-Pa.) noted the Federal Reserve has the discretion to modify the application of the liquidity coverage ratio (LCR), especially for large regional banks that are not GSIBs and smaller banks, and asked if the Federal Reserve is making progress on changes to how the LCR is applied to banks bigger than $250 billion. Quarles said they are working to determine how to appropriately tailor regulations, and that they are waiting to see how legislative activity in this area plays out.

Brown also asked about the Federal Reserve’s proposed changes to the Comprehensive Capital Analysis and Review (CCAR). Quarles said that based on an analysis of 2017 data, the capital consequences would vary from firm to firm but for the globally systemically important banks (GSIBs) capital would modestly increase, for non-GSIBs it would modestly decrease, and the overall change would be flat.

Several senators asked about the systemically important financial institution (SIFI) threshold. Crapo discussed changes to the threshold, asking if the change from $50 billion to $250 billion threshold would still give the Federal Reserve the ability to supervise and regulate. Quarles replied that he was supportive of efforts to tailor regulation, and does think the measure in S. 2155 to raise the SIFI threshold would leave the Federal Reserve with full ability to protect safety and soundness.

Brown asked Quarles to commit to not raising the $50 billion threshold for intermediate holding companies, to which Quarles responded there was nothing in S. 2155 that would require the Federal Reserve to change its approach to foreign banks.

Toomey said that raising the automatic SIFI designation threshold from $50 billion to $250 billion was very important, noting that it is important to have a regulatory framework primarily based on the activities of the institution rather than an “arbitrary” asset designation. Quarles said ideally there would be a variety of factors taken into account in applying enhanced standards, taking into account a full range of aspects in determining how to tailor regulation.

S. 2155, the Economic Growth, Regulatory Relief and Consumer Protection Act

A number of senators asked about the effects of S. 2155, the Economic Growth, Regulatory Relief, and Consumer Protection Act. Crapo asked what benefits result from a regulatory system that is less complex and more transparent, to which Quarles replied that it results in improved compliance, lower costs, and a greater ability to achieve the objectives of the underlying regulations.

Senator Brian Schatz (D-Hawaii) noted that several financial institutions have recently reported record profits, asking for evidence that deregulation is necessary and whether it is resulting in more capital being made available to small businesses and individuals. Quarles said that it isn’t an effort to deregulate, but rather to achieve regulatory objectives in more efficient way. Quarles continued that the regulatory burden has contributed to a shortage of small business credit, and that there are economic studies that show the benefits will be spread among constituencies.

Senator Elizabeth Warren (D-Mass.) also asked about changes to capital requirements, expressing concern that large banks will be able to reduce their capital by large margins. Quarles replied that their estimates of the capital effect are much smaller, but agreed that leverage capital measures are an important element of capital regimes. Warren also asked if, under S. 2155, large banks would qualify for the adjustments to capital requirements designed in the legislation for custody banks. Quarles replied that, under his reading of the provision, large banks such as JP Morgan and Citi would not qualify.

Senator David Perdue (R-Ga.) asked Quarles for his opinion on how well capitalized U.S. banks are today. Quarles responded that relative to peer banks around the world, U.S. banks are extremely well capitalized. Perdue continued by asking that given U.S. banks’ well capitalized position as well as our accelerated implementation of Basel III, what is Quarles’ opinion of any further implementation of the Basel III agreement relative to what other signatories are doing. Quarles said that he believed the U.S. is probably ahead of many other jurisdictions, but keeping a level playing field across nations is something that the board takes into account when both encouraging others to come up to standard as well as in the roll out the United States’ own regulations.

Perdue said that if the Banking Regulatory Relief Bill becomes law, the Federal Reserve will have the opportunity to determine which banks will be given relief for enhanced supervision. He continued that he currently has a bill which would require the use of the Basel five-part test in designating G-SIBs. Perdue asked for Quarles’ opinion on this as well as how he feels about an asset sized-based approach as opposed to an activity-based approach in determining risk for banks of this size. Quarles responded that those determinations should be made by considering a range of factors, size being only one of them, and that he does support moving more towards a multi-factor approach to evaluating risk.

FINRA Rule 4210

Senator Tom Cotton (R-Ark.) discussed FINRA Rule 4210, which established margin requirements that determine the amount of collateral customers are expected to maintain in margin accounts. Cotton stated that the rule is applied to broker-dealers and not banks, so bank-affiliated broker-dealers can use their banking arm to avoid the requirement, creating an uneven playing field for smaller broker-dealers. Quarles stated that a level playing field is important across a range of issues, and it is a high priority to ensure regulation addresses this. He affirmed he will look at the rule through this lens in his review.

Volcker Rule

Senator Thom Tillis (R-N.C.) stated that Quarles had recently discussed how the Volcker rule has been detrimental to our capital markets and has created a great deal of uncertainty. Tillis noted that there is a House bill to streamline the Volcker rule which recently passed, and asked Quarles to discuss the consequences of having five different regulators enforcing the rule, as well as how the bill could be streamlined to be less problematic. Quarles responded that there is a logic to the provision of having five regulators enforcing the rule as they each have supervisory authority over entities that are affected, however there are logistical consequences to this. He noted that cooperation he has seen since the beginning of the year from the other regulators on working to revise the rule has been very productive and has been moving well.

Community Reinvestment Act (CRA)

Several senators asked about possible revisions to regulations implementing the Community Reinvestment Act (CRA). Senator Doug Jones (D-Ala.) said that while modernizing is important, there are disparities around the country and rules should appropriately reflect the needs of specific communities. Quarles responded that the purpose of CRA modernization is to direct it at a broader range of community development activities. Menendez asked if the Federal Reserve and Office of Comptroller of the Currency (OCC) would join in a forthcoming rulemaking, and Quarles replied he expected it to be a joint proposal.

Senator Chris Van Hollen (D-Md.) asked if Quarles would examine a report from the Center for Investigative Reporting which found that redlining and discrimination surrounding mortgage lending continues today, and if Quarles could help determine where the system is failing and get back to him with his findings. Quarles responded that this was a very reasonable request and he would do so.

Cybersecurity

Jones asked how the Federal Reserve is working with international regulators to address cybersecurity. Quarles said cybersecurity is the most significant risk the financial sector is facing, and the international aspect is important to consider. Quarles said that in discussions among regulatory agencies around the world, cybersecurity is the highest priority item and that there is much more to do to ensure our systems are resilient.

Senator Jack Reed (D-R.I.) noted that the Fed, OCC, and FDIC issued an Advanced Notice Proposed Rulemaking on cybersecurity, and asked Quarles for an update on it. Quarles responded that he thinks regulators need to step up the pace with measures to help support the resiliency of the system, and the ANPR is an example.

Firearms

Crapo asked if the “reputation risk” of doing business with the National Rifle Association (NRA) and others in the gun industry was relevant to the safety and soundness of financial institutions under the Federal Reserve’s supervision. Quarles replied that he does not believe doing business, or not doing business, with the NRA or gun industry raises safety and soundness questions, so it is outside their remit as regulators.

Senator John Kennedy (R-La.) asked if the decision not to do business with the gun industry would violate state and local nondiscrimination laws, or any federal laws. Quarles replied that while they should not impose their personal views, it is their responsibility as supervisors to investigate whether financial institutions are following state, local, and federal laws.

Incentive Compensation

Senator Robert Menendez (D-N.J.) asked about incentive compensation, and whether the Federal Reserve had an update on rulemaking to prohibit incentive compensation that rewards irresponsible risk-taking.  Quarles said it was as important issue on the agenda, but declined to give a timeframe. Quarles continued that addressing a culture of an organization is an “extremely complex matter.”

GSEs

Senator Heidi Heitkamp (D-N.D.) asked Quarles if he thought Fannie Mae or Freddie Mac could fail again. Quarles said he would have to take a deeper dive to answer that question, but that there is a possibility they could. Heitkamp then asked whether there was a likelihood that one or both could take a draw from their line of credit with Treasury soon. Quarles replied that when he was at Treasury they proposed strict controls and Treasury does have the ability to limit that, but there is a possibility Fannie and Freddie could.

For more information on this hearing, please click here.