The Split Over Supervision

By | January 22, 2021

Prudential supervision has always been a core principle of federal bank regulation since President Lincoln signed into law the National Bank Acts of 1863 and ’64. More than 150 years later, the rise of data analytics and a pendulum swing in favor of legal formalism appears to be driving a split in how supervision should be conducted, with the future of bank regulation in the balance.

Bank supervision has always existed in one form or another. Through history, supervision has relied on the judgment of individual examiners to determine whether each bank operates in a safe and sound condition or poses risks to the financial system and deposit insurance fund. Today, examiners review banks’ books and policies on site at least once every 18 months and score banks on the CAMELS rating system (Capital adequacy; Asset quality; Management capability; Earnings quality; Liquidity adequacy; and Sensitivity to market risk). In addition, the largest banks—those of global systemic importance—are subject to recurring “horizontal reviews” of their capital and liquidity adequacy.

Banks’ CAMELS ratings are largely left to the discretion of examiners; although agency headquarters issues the framework and guidelines, examiners throughout the country are the ones to review loans and collateral, board and c-suite management decisions, liquidity risk management, and other activities. Examiners use their experience and judgment to apply what they’ve learned from examinations to the ratings framework.

One side of the developing divide over supervision largely supports maintaining the current supervisory system, with expert judgment being a significant and important part of bank regulation. In a forthcoming paper, former Federal Reserve Governor and current professor Daniel Tarullo writes that supervision, in addition to “monitoring … bank compliance with regulatory rules,” can offer banks “an informed, independent assessment of their own” activities. Such assessments can include evaluating whether “the underwriting process followed by a bank is sufficiently rigorous,” whether “assets are being correctly categorized for purposes of risk-weighting,” and whether banks have the “experience or capacity” to succeed in new areas of business. To make these decisions and others, examiners must have some capacity for independence from regulatory guidelines. Tarullo has posited a very traditional view of supervision.

The other side of the split supports restricting examiner discretion in the name of clear and predictable rules. In a recent speech, Federal Reserve Vice Chair for Supervision Randal Quarles criticized the “inherently more judgmental, nuanced, discretionary, variable, and opaque” nature of supervision and expressed concern that supervisory ratings may not be “consistent when administered in different circumstances by different people,” which may result in material consequences for institutions. Legal privileges, such as the right to operate broker-dealer affiliates which provide for lower funding costs than bank deposits, are granted to institutions that are well-managed; thus, firms with lower ratings may face competitive disadvantages relative to their higher-rated peers. If there is inconsistency between examiner ratings, firms may be unfairly penalized due to no fault of their own.

Lamenting that “we don’t have a particularly well-developed theory of ratings” that offers “consistency and predictability” in supervisory ratings, Quarles expressed support for “clear quantitative standards” that allow for data analytics to decide how firms are affected by regulations, rather than examiners’ more subjective judgments. He lauded the stress capital buffer’s “clear and explicit capital target” that lets firms know whether and at what level they may offer dividends without first requesting regulatory approval. To that end, Quarles proposed a variety of changes to the rating system that would apply an algorithm to the extent feasible, allow banks the opportunity to comment on guidance given to examiners in how to interpret the rating standards, and otherwise reduce the discretion of individual supervisors. This perspective is generally supported by the banking industry.

Although both sides view supervision as necessary to prevent the moral hazard that comes from federal backstops such as deposit insurance and access to the discount window, the divide between these two perspectives is stark. It has been described on this blog as one side viewing examiners as fire wardens who ensure that the banks and the banking system do not burn down, while the other side views examiners as cops on the beat, looking to enforce the law. Tarullo emphasizes the benefits of supervision, not only in reducing risks to the banking system but also in offering constructive criticism to banks’ management in such ways that help improve banking as a whole. In contrast, Quarles emphasizes the costs to financial institutions of the uncertainty that stems from examiners’ judgments, viewing the “simpler, more consistent, more predictable, and more efficient” standards in codified rules as preferable to prudential supervision, with examiners necessary to ensure compliance with those regulations. Both views clearly want a safe banking system but view the purpose of supervision through different lenses.

I predict that supervision in the near future looks more like Vice Chair Quarles’ vision than Professor Tarullo’s. In many areas of law, there is a growing movement to push for black-and-white legal standards that do not rely on the expert judgments of government officials for their enforcement (and that generally grant wider latitude to businesses than current standards). The Trump Administration issued several executive orders promoting this view within agencies, and courts are poised to strike down laws and regulations that grant too much discretion to government officials. Further, technological advances have made the data analytics necessary to effectuate quantified standards possible, providing an alternative to classical supervision that was previously impracticable.

Although it is unlikely the new Biden Administration’s regulators will intentionally adopt this movement’s posture towards regulation and supervision, it may be difficult to propose policies that allow individual examiners to shape the details when the entities being supervised are encouraging them to do otherwise. Further, Quarles still has nearly 10 months left on his term as Vice Chair for Supervision, allowing him to further cement his conception for supervision in Federal Reserve Board policy and culture before President Biden can name a successor.

Of course, only time will tell which vision truly is the future of bank supervision.

 

Todd Phillips is a government lawyer in Washington, D.C. This article expresses the author’s personal views alone.

Leave a Reply

Your email address will not be published. Required fields are marked *