Anyone Know a Good Tailor?
Wayne A. Abernathy
It is difficult to find a public statement by a financial services policymaker these days where the policymaker does not invoke the importance of tailoring bank regulation and supervision. This is major progress from the days of one-size-fits-all programs. A fundamental characteristics of the U.S. banking system is its diversity of business models, developed over the years to match the diversity of financial services customers. Can bank supervision be tailored to accommodate that diversity?
Perhaps, but there is tailoring and there is tailoring. The crudest tailoring can offer some progress, but it can be fraught with its own problems. I refer to tailoring regulations and supervision based upon one and only one criterion: size of the institution. That is simple, because it is easy to define and measure. Still, it too frequently corresponds poorly to the real purpose of tailoring, i.e. to make sure that the administration of the rule matches closely the risk to be addressed.
The Dodd-Frank Act mandated that any bank with more than $50 billion in assets be treated as a Systemically Important Financial Institution (SIFI), calling down elaborate enhanced supervision requirements. The number was derived entirely from the air that we breathe. Experience has fed a consensus that many banks dubbed SIFIs by law are not genuinely SIFIs in practice, whose failure would bring down the financial system. At the same time, banks were restricting growth, turning away business to shun that SIFI threshold and the avalanche of regulation that came with it. Congress lately enacted legislation to begin to address some of that SIFI problem.
Another example, consider the Volcker Rule. Explained as addressing systemic risks believed to be caused by banks trading in the markets with their own funds rather than on behalf of customers, this very late addition to the Dodd-Frank Act was applied to all banks, pretty much one-size-fits-all. The regulators, who were not enamored of the provision, sought to tailor it to some degree by reducing compliance burdens for smaller banks. That was a welcome step for those banks, though compliance tasks remained, despite no systemic impact from their activities. For banks that did not receive that relief, full Volcker Rule compliance continued, also without reference to actual systemic risks.
In recent weeks, Congress acted and regulators proposed to act. Congress legislated that the Volcker Rule not apply to any bank with less than $10 billion in assets, unless it actually was significantly involved in trading. The Federal Reserve, the FDIC, and the Office of the Comptroller of Currency about the same time proposed a rule that would vary the compliance and supervisory requirements of the Volcker Rule based not upon the size of an institution but rather upon the size of its trading book. That is an important and valuable form of tailoring focused on the risk intended to be addressed.
There may be a trend. In a June 27 speech to Utah bankers, Federal Reserve Vice Chairman for Supervision, Randal Quarles, declared that, “Banks of all sizes have a shared interest in ensuring that regulation is efficient and appropriately tailored to promote a strong, fair, and competitive market for financial services.” He then announced an example of risk-based tailoring at the Federal Reserve:
One supervisory improvement is a Federal Program called Bank Exams Tailored to Risk, or the BETR program. It uses financial metrics to differentiate the level of risk between banks before examinations and assist examiners in tailoring examination procedures . . .
Vice Chairman Quarles went on to declare that, “As the Fed continues to evaluate the effectiveness and efficiency of regulations, I expect tailoring will be a guiding principle.” There is ample opportunity for that exercise, as the new reform law directs the Fed to create within 18 months a new tailored supervision program for banks with between $100 billion and $250 billion in assets. Building upon that limited tailoring experience, the Fed is also to apply tailoring to supervision of larger banks.
Basing bank supervision on a bank’s “capital structure, riskiness, complexity, financial activities (including financial activities of subsidiaries), size, and any other risk-related factors” that the regulator deems appropriate, to quote from section 201 of the statute, should mean by definition a better alignment of supervision with actual risk. Hard work, but the prospect is promising.