HFSC Hearing with Fed’s Quarles

House Financial Services Committee

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

Wednesday, November 14, 2018

Key Topics & Takeaways

• Volcker Rule: Reps. Jeb Hensarling (R-Texas) and French Hill (R-Ark.) questioned the Federal Reserve’s Vice Chairman for Supervision Randal Quarles on the Volcker Rule and the idea of simplifying the rule by unifying it under one rulemaking authority and one regulatory authority as H.R. 4790 lays out. Quarles replied that he is familiar with it, and that without such legislation it would require an interagency agreement, something the Fed could do, but questioned how sustainable it would be crossing multiple administrations and heads of agencies.
• Margin Requirements: Reps. Blaine Luetkemeyer (R-Mo.) and Frank Lucas (R-Okla.) asked about inter-affiliate margin requirements, and Quarles acknowledged that the U.S. is isolated in this requirement, adding that the Fed must look at this closely. He continued that there are ongoing internal discussions on this topic at the Fed and that it is a personal priority of his to address the issue. Quarles added that the Fed has a rule dealing with affiliate transactions, protecting against exposures created by affiliate transactions, that may be satisfactory to move the U.S. into compliance with the rest of the world.
• Foreign Banking Organizations and the Tailoring Proposal: Reps. Andy Barr (R-Ky.) and Trey Hollingsworth (R-Ind.) noted that FBOs were omitted from the tailoring proposal, to which Quarles stressed the importance of FBOs to the domestic economy and noted that there will be a process to ensure there is a level playing field for them while also realizing their differences to domestic banks.

Witness

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

Opening Statements

Rep. Jeb Hensarling (R-Texas), Chairman, House Financial Services Committee

In his opening statement, Hensarling noted that Dodd-Frank “dramatically” increased the power of the Federal Reserve (the Fed) beyond its traditional monetary policy responsibilities, saying that through heightened prudential standards, the Fed can “functionally control” the largest financial institutions, calling it “disconcerting.” Hensarling said that increased capital and liquidity standards add to stability, if they are not counterproductive or duplicative, but regulatory complexity and micromanagement do not, adding that if regulations are not properly tailored and calibrated, they can hinder economic growth. Hensarling highlighted that the Fed recently proposed changes to supervisory requirements for some financial institutions, a result of the House-led deregulatory and pro-growth provisions in S. 2155, noting that while they are a welcome sign of progress, do not yet represent full success. Hensarling said the committee has devoted much time and attention to properly tailor financial regulation, adding that he was pleased to see the Fed’s willingness to better tailor, perform cost-benefit analysis, implement prudential regulation risk adjustments, and propose amendments to the Volcker Rule.

Rep. Maxine Waters (D-Calif.), Ranking Member, House Financial Services Committee

Waters noted the “harmful effects” of regulatory rollbacks and the “weakening” of capital standards for large banks, saying that capital standards are an “effective method” for preventing bank failures and the “days of the Committee weakening regulations will come to an end.” Waters said Dodd-Frank created Quarles’ position at the Fed to help rectify its “inadequate” supervision and enforcement prior to the financial crisis, adding that is is “essential” for the Fed to keep a watchful eye on the entities it supervises and to make strong use of its enforcement tools. Waters said she is concerned about proposals to reduce capital and liquidity requirements, saying it would weaken strong safeguards in Dodd-Frank to protect from another financial crisis, and that the current standards have strengthened the resiliency of the largest banks and the entire financial system without undermining economic growth.

Rep. Blaine Luetkemeyer (R-Mo.)

Luetkemeyer noted that the Fed has taken steps to right-size regulation, saying it is “imperative” to take a more practical approach to supervision. Luetkemeyer said that regarding enhanced prudential standards, the Fed has a strong system in place and a systemic risk score indicator, and though the latest proposal “goes in a different direction,” he is glad to see the Fed undertaking a more risk-based approach to regulation. Luetkemeyer encouraged the Fed to remain flexible, to revisit arbitrary thresholds, and to steer federal supervision to an even more risk-based approach taken on an institution-by-institution basis. Luetkemeyer added that the Fed should also consider tailoring for U.S. intermediate holding companies of foreign banks, and accommodations for smaller institutions that do not pose systemic risk.

Rep. Bill Huizenga (R-Mich.)

Huizenga discussed the Fed’s commitment to tailoring regulation while ensuring safety and soundness. Huizenga noted the importance that reforms take into consideration an institution’s size and other risk factors, not just “arbitrary” thresholds. Huizenga said that he agrees with the assessment that the Volcker Rule is an example of a complex regulation that is not working well, and it is important to work towards a more simplified rule that is tailored to fit financial institutions.

Testimony

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

In his testimony, Quarles addressed the Fed’s efforts to improve regulatory transparency and their progress in making the post-crisis regulatory framework simpler and more efficient, including improving the supervisory rating system for large financial institutions to better align the rating with the supervisory feedback those firms receive. Quarles said the Fed expects to soon make final a set of measures to increase visibility into their stress testing program, including more granular descriptions of models, more information on the design of scenarios, and more details on projected outcomes. Quarles said that improving regulatory efficiency is also core to their efforts, and that tailoring regulation and supervision to risk is a programmatic goal. He noted that activities and firms that pose the greatest risk should receive the most scrutiny, and where risk is lower, so should be the regulatory burden.

Quarles noted that the Fed has released two recent proposals to better align prudential standards with the risk profile of regulated institutions. Quarles said the proposals would “significantly reduce” regulatory compliance requirements for firms in the lowest risk category, including most institutions with assets between $100-$250 billion in total assets. Quarles continued that the Fed expects to make progress on a number of issues, including simplifying and tailoring requirements under the Volcker Rule and working with their counterparts at the Office of the Comptroller of the Currency (OCC) and Federal Deposit Insurance Corporation (FDIC) on a community bank leverage ratio proposal.

Questions & Answers

Comprehensive Capital Analysis and Review (CCAR)

Hensarling noted that in Quarles’ April appearance before the Committee, he stated the Fed could drop the qualitative aspect of CCAR and questioned why it has only been removed for Category IV institutions (firms with $100-250 billion in total assets) in the recently proposed framework. Quarles replied that the Fed does have the power and that maybe the time has come to move the qualitative objection into the regulatory supervisory engagement with firms, rather than having a separate process.

Volcker Rule

Reps. Hensarling and French Hill (R-Ark.) questioned Quarles on the Volcker Rule and the idea of simplifying the rule by unifying it under one rulemaking authority and one regulatory authority as H.R. 4790 lays out. Quarles replied that he is familiar with it, and that without such legislation it would require an interagency agreement, something the Fed could do, but questioned how sustainable it would be crossing multiple administrations and heads of agencies.

Huizenga asked about covered funds and what rationale there is for allowing banks to invest on their balance sheet while preventing it in a fund structure, which would make the investment safer because it has more investors than solely the bank. Quarles replied that in the Volcker Rule proposal they have requested comments on how to handle covered funds and going through them is part of the Fed’s next step.

Regulatory Reform

Several Democrats questioned the Fed deregulating the largest banks, to which Quarles argued that the Fed is recalibrating regulations so incentives facing the financial sector are appropriately aligned, which will not increase risk in the system. He continued that the Fed is implementing S. 2155 as they have been tasked with, which will reduce the compliance burden on less risky firms and not materially impact the resiliency of the financial system.

Waters then asked for Quarles’ commitment to not reducing the capital levels for the global systemically important banks (GSIBs), to which Quarles replied that it is not his intention and that right now the levels seem “just about right.”

Rep. Brad Sherman (D-Calif.) asked when the Fed will define “tangible equity capital,” to which Quarles replied “soon.” Sherman then asked when the Fed will propose new capital rules for regional banks, and Quarles replied that the October 31st proposal is intended to cover the entire industry.

Rep. Trey Hollingsworth (R-Ind.) asked for additional ways to make the regulatory environment more efficient, to which Quarles replied that the Fed needs to think about leveling the international playing field for the largest firms.

Stress Tests

Hensarling asked Quarles to clarify what the Fed intends to share with the industry regarding stress tests, to which Quarles replied that the Fed intends to reveal more about the models and losses that are expected due to different stressors so banks can compare with their own models. He continued that the Fed intends to be more transparent with each stress test iteration, noting that the Fed will seek input from the public regarding scenario design.

Rep. Patrick McHenry (R-N.C.) asked about removing the leverage ratio from stress test capital requirements. Quarles replied it appropriately aligns regulation, adding that while stress tests are firm-specific and risk-based, the leverage ratio is intended to be non-risk-sensitive and solely serve as a backstop.

Rep. Carolyn Maloney (D-N.Y.) questioned Quarles’ recent comments about removing the stress leverage buffer from the stress test regime, to which Quarles replied that banks will still be subject to leverage requirements, just not in the stress test.

Rep. David Scott (D-Ga.) voiced his concern about the Fed increasing stress test transparency, and Quarles replied that the Fed can be more transparent “without giving away the test.” He continued that they could make clearer the broad categories of assets and models included, rather than every category of assets and scenarios.

Bank Secrecy Act/Anti-Money Laundering (BSA/AML)

Reps. McHenry, Nydia Velazquez (D-N.Y.) and Gregory Meeks (D-N.Y.) asked about updating and improving BSA/AML rules and processes. Quarles replied that they could benefit from increased use of financial technology, as it is an efficient use of bank resources. Quarles added that the Fed is supportive of bank efforts to share resources for BSA/AML activities, as well as taking advantage of cost reduction by using new technology. He continued that the Fed is working with the Department of Treasury and the Financial Crimes Enforcement Network (FinCEN) to review banking agency’s examination and enforcement practices, as well as Treasury and FinCEN’s rulemaking on BSA/AML.

Financial Technology (FinTech)

McHenry asked Quarles why the Fed does not encourage banks to partner with technology companies to keep up with the rest of the technology sector, to which Quarles replied that it is an “interesting thought.” He continued that he wants to make sure there are partnerships that regulators understand, as well as any risk in those partnerships, but that the Fed has no reason to “stand in the way.”

Rep. Scott Tipton (R-Colo.) discussed recent comments by Treasury’s Craig Phillips that the U.S. could potentially be “left behind” compared to global competition if regulators do not provide proper coordination guidance and asked whether it needs to be statutory and regulatory guidance, to which Quarles replied that it can be either and that regulators can provide steps for the industry.

Margin Requirements

Luetkemeyer noted that the Committee has previously passed legislation that would require regulators to recognize the exposure-reducing nature of client margin for cleared derivatives, noting that the Fed’s Standardized Approach for Counterparty Credit Risk (SACCR) recognized this.

Reps. Luetkemeyer and Frank Lucas (R-Okla.) discussed inter-affiliate margin requirements, explaining that the current system requires firms to post margin multiple times on a single transaction, unnecessarily locking up capital, adding that European and Asian regulators do not have this requirement, nor does the Commodity Futures Trading Commission (CFTC) for non-bank entities. Quarles acknowledged that the U.S. is isolated in this requirement, and that the Fed has to look at this closely. He continued that there are ongoing internal discussions on this topic at the Fed and that it is a personal priority of his to address the issue. Quarles said that the Fed has a rule that deals with affiliate transactions, protecting against exposures created by affiliate transactions, that may be satisfactory to move the U.S. into compliance with the rest of the world.

Lucas discussed H.R. 4659, which would offset initial client margin when calculating the supplemental leverage ratio (SLR), noting that it cleared the Committee with bipartisan support. He noted that the Fed’s recent leverage ratio methodology included a question about offsetting for client margin and asked what additional information the Fed is expecting to receive. Quarles replied that there is “always more information to be gained” and that the Fed should be open to changing the treatment of initial margin in this way.

Rep. Steve Stivers (R-Ohio) echoed Luetkemeyer and Lucas, adding that inter-affiliate margin requirements have led to $29 billion being “locked up” that does not need to be, as the money could better be used creating jobs and capital. Quarles replied that he looks forward to working with the Committee on the issue.

Current Expected Credit Losses (CECL)

Reps. Luetkemeyer, Hill, Barry Loudermilk (R-Ga.) and Ted Budd (R-N.C.) raised concern over unintended consequences of CECL, to which Quarles replied that the implications for small and large firms are not currently known, but the phased-in implementation should give them time to see the impact before it adds to loss absorbency and the capital regime.

Community Reinvestment Act (CRA)

Several Democrats discussed the importance of the CRA and questioned why the OCC came out with their own proposal without the Fed and FDIC, to which Quarles replied that what the OCC released was an advanced notice of proposed rulemaking (ANPR) and he still expects there to be a joint rulemaking.

Regulatory Coordination

Velazquez questioned whether better coordination is needed between the foreign banks and the Fed, to which Quarles replied that the supervision of foreign banks “is not deficient,” and that there is good cooperation with home country supervisors, which is “important for those positions.”

Systemically Important Financial Institution (SIFI) Designation

Sherman asked if there is a need to codify an activities-based approach to non-bank SIFI designations, to which Quarles replied that the Financial Stability Oversight Council (FSOC) is engaged in a “robust” process in implementing an activities-based approach, adding that he thinks FSOC will “get there soon” and that the process “will be well done.”

Proposed Changes to Prudential Standards

Rep. Maloney noted her concern about scaling back the liquidity rules for Category III banks (those with over $250 billion in total assets), questioning the need to deregulate when the system is working. Quarles replied that he does not believe the tailoring will impact liquidity.

Reps. Andy Barr (R-Ky.) and Trey Hollingsworth (R-Ind.) noted that foreign banking organizations (FBOs) were omitted from the tailoring proposal, to which Quarles stressed the importance of FBOs to the domestic economy and noted that there will be a process to ensure there is a level playing field for them while also realizing their differences from domestic banks.

Tipton asked why the tailoring proposal is important for the supervisory scheme of the Fed, to which Quarles replied that the nature and character of a regulation should match that of the firm, that more risky and complex institutions should have regulations that address that while simpler firms and activities are not subject to such regulations.

Supplemental Leverage Ratio

Reps. Keith Rothfus (R-Pa.) and Lynch discussed H.R. 2121, which exempts cash deposits from the SLR, and how a similar provision was included in S. 2155, asking when the Fed will be implementing it. Quarles replied that while he does not have an exact date, the Fed will be working on it soon.

Cryptocurrency

Perlmutter asked about crypto and digital currencies, how the Fed takes in new currencies, and how they are looked at in terms of liquidity. Quarles responded that the current characteristics of cryptocurrencies do not result in them being considered “money,” but rather as an “asset.” Quarles said these cryptoassets have been highly volatile in price, making them less appealing as a store of value. Quarles added that there are concerns about consumer protection and criminal activity, and that while they aren’t factored into considerations of the money supply right now, years from now they could evolve into a payment system.

Cybersecurity

Stivers noted that Quarles has attributed cyber threats to “poor technology hygiene” and asked how cyber insurance could create safe harbors and the right coverage to cover liabilities. Quarles said he hadn’t thought about it before but finds the idea interesting and will add it to his list of issues to explore further.

Government-Sponsored Entities (GSEs)

Rep. Ed Royce (R-Calif.) discussed placing Fannie Mae and Freddie Mac into conservatorship and how the current administration could possibly release the GSEs, which would raise “serious issues” from a monetary policy standpoint. He asked Quarles if he had any thoughts on what it would mean for the Fed, to which Quarles replied that he shares the concern and that the Fed must ensure the risk around the GSEs is handled appropriately and that their structure does not create systemic risk.

For more information about this hearing, click here.