April 17, 2018

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

Key Topics & Takeaways

• Fed Guidance: Rep. Blaine Luetkemeyer (R-Mo.) asked if banks should consider guidance “binding rules” even though it has not gone through a notice and comment period. Quarles replied that it is not binding, and that if it was, it would go through a transparent rulemaking process. He stressed that he has communicated that “guidance is guidance, rules are rules” to examiners, and is working on the best way to formalize this.
• Prudential Regulation: Rep. Carolyn Maloney (D-N.Y.) noted that both the Senate banking bill and Fed/OCC joint proposal amend the supplemental leverage ratio (SLR) and asked if they work together or if one is unnecessary. Quarles replied that the two propose different approaches and should the banking bill become law the Fed and OCC will have to consider how to calibrate their proposal so they work together.
• International Coordination: Maloney and Rep. Warren Davidson (R-Ohio) asked about engagement with international groups, such as the Financial Stability Board or Basel Committee, to which Quarles said that participation in these committees ensures a level playing field for the U.S., though transparency within the groups could be improved.
• Volcker Rule: Quarles fielded numerous questions regarding the Volcker Rule and the revision to the rule currently being discussed by financial regulators. Quarles declined to endorse specific changes to the rule, though he did argue that the Rule has had an impact on liquidity in capital markets (though he noted substantial disagreement on the impact from economists). Quarles also said that exemptions for small institutions would not create systemic risks and said he was aware of the impact of Volcker on diversified industrial companies that also own depository institutions.

Witness

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

Opening Statements

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

In his opening statement, Hensarling noted that it has been eight years since there was a Vice Chairman for Supervision at the Fed, and that he is happy President Trump appointed him, as former President Obama “refused” to permanently fill the position. He noted that it is Tax Day and that 90 percent of Americans are bringing home more pay because of the new tax bill but added that although there is a three percent growth tax code, there is still a need for three percent growth in the capital markets and banking policy. Hensarling welcomed Fed Vice Chair Randy Quarles’ call for simplicity, transparency, and efficiency in Fed rulemaking and oversight, stressing the need for the Fed to ensure cost-benefit analyses are conducted.

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

In her opening statement, Waters echoed Hensarling’s welcome to Quarles and stated that his job is critical to ensuring the financial system remains safe and sound. She stated that the Fed’s independence is “under attack” and questioned the Office of Management and Budget’s (OMB’s) Director Mick Mulvaney over his lack of enforcement action by the Consumer Financial Protection Bureau (CFPB) since he took over as acting director. Waters questioned efforts by the administration and Republicans to dismantle the Dodd-Frank Act and the recent proposal by the Fed to lower the capital buffer of the eight largest banks.

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” system. He continued that the public is not only interested in the safety and soundness of the financial system. 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 Fed’s regulatory framework.

Question & Answer

Fed Guidance
Rep. Blaine Luetkemeyer (R-Mo.) asked if banks should consider guidance “binding rules” even though it has not gone through a notice and comment period. Quarles replied that it is not binding, and that if it was, it would go through a transparent rulemaking process. He stressed that he has communicated that “guidance is guidance, rules are rules” to examiners, and is working on the best way to formalize this.

In response to a question from Rep. Warren Davidson (R-Ohio), Quarles replied that Fed guidance would benefit from the comment process even though it is not a rule, as comment improve the content.

Cost-Benefit Analysis
Luetkemeyer asked about the new department in the Fed that will conduct cost-benefit analysis on regulations, to which Quarles replied that the group of economists will be ensuring regulations are effective in reaching their obligation.

Rep. Roger Williams (R-Texas) asked what factors the Fed is looking for when reviewing regulations, and whether the results will be made available to Congress. Quarles replied that a significant part of the review is the cost of the regulation, but that they are looking “across a broad range of effectiveness,” adding that they are unsure how to make them public as of now.

Rep. French Hill (R-Ark.) asked if Quarles is supportive of the Fed looking at all Fed rules regularly and conducting cost-benefit analyses, to which Quarles agreed, adding that the Fed “need[s] to do a better job of that.”

Prudential Regulation
Rep. Carolyn Maloney (D-N.Y.) noted that both the Senate banking bill and Fed/OCC joint proposal amend the supplemental leverage ratio (SLR) and asked if they work together or if one is unnecessary. Quarles replied that the two propose different approaches and should the banking bill become law the Fed and OCC will have to consider how to calibrate their proposal so they work together.

Maloney then noted the Fed’s proposal to increase transparency for stress tests and that it is “more than adequate,” asking what additional disclosures he thinks should be made. Quarles replied that the Fed is combing through the comments received on the proposal, and that an example of where they may provide additional transparency would be to provide a period of input from the public on the scenarios used each year.

Rep. Nydia Velasquez (D-N.Y.) stated that the Chairman of the Federal Deposit Insurance Corporation (FDIC) did not sign on to the Fed/OCC eSLR proposal due to the reductions in capital requirements. Quarles replied that when the Fed and OCC were evaluating the change, they weighed the “relatively modest capital reduction against the benefit of changing incentive,” and that ultimately it was the “right time to do it.”

Rep. Andy Barr (R-Ky.) asked if the qualitative portion of CCAR would eventually be phased out for all banks. Quarles said that step would be discussed at an appropriate time. Barr also asked if the Fed would solicit public comment on the severely adverse stressed scenario for future CCAR tests, and Quarles said that the Fed would be interested in some form of public comment on those scenarios.

Rep. Ed Royce (R-Calif.) asked Quarles how the Fed’s view of the current economic cycle impacted its thinking on capital requirements. Quarles said that banks should build capital in good times to survive stressed periods, and that countercyclical tools like stress tests should be used to ensure banks are sufficiently capitalized. Quarles also pointed out that consistency in regulations is important to allow financial institutions to plan.

Hensarling noted the Fed’s announcement that it would no longer object to a company’s capital plan based upon the qualitative deficiencies for banks under $250 billion and asked if the Fed is considering this, to which Quarles replied yes.

G-SIB Surcharge
Rep. Trey Hollingsworth (R-Ind.) discussed the importance of the G-SIB surcharge and that the calculation should be updated so coefficients reflect economic growth, to which Quarles replied he would have to look at the calculation as it was created many years ago.
Regulatory Coordination
Maloney and Davidson asked about engagement with international groups, such as the Financial Stability Board or Basel Committee, to which Quarles said that participation in these committees ensures a level playing field for the U.S., though transparency within the groups could be improved.

Rep. Sean Duffy (R-Wis.) noted that the International Association of Insurance Supervisors (IAIS) is developing international capital standards like the European solvency standards, to which Quarles stated that the U.S. state-based insurance regulatory model is effective here, and that in negotiating with the IAIS, the Fed would not do anything to impact the distribution of insurance regulation in the U.S.

Rep. Scott Tipton (R-Colo.) asked if the Fed is working with other regulators when it comes to simplifying capital rule and stress test requirements, to which Quarles replied yes, that they are working to ensure principles are applied uniformly across regulators, but that negotiations are difficult.

Volcker Rule
Quarles fielded numerous questions regarding the Volcker Rule and the revision to the rule currently being discussed by financial regulators. Quarles declined to endorse specific changes to the rule, though he did argue that the Rule has had an impact on liquidity in capital markets (though he noted substantial disagreement on the impact from economists). Quarles also said that exemptions for small institutions would not create systemic risks and said he was aware of the impact of Volcker on diversified industrial companies that also own depository institutions.

Rep. Bill Huizenga (R-Mich.) asked how the Fed is working with to implement the Volcker Rule, to which Quarles replied that all five Volcker agencies are working together to create a “revised” Volcker Rule proposal. He continued that it is “unarguable” that the rule is detrimental to the capital markets and that it creates excessive burdens. Quarles explained that although there are limits to any changes to the rule the regulators can make, they can reduce the burden of application and increase the certainty of application.

Rep. Randy Hultgren asked Quarles how regulators will ease Volcker compliance for smaller financial institutions. Quarles argued that a clearer definition of what constitutes proprietary trading, and changes to the deployment of supervisory resources, could ease compliance for smaller institutions.  Rep. Mia Love (R-Utah) brought up H.R. 4790, which would exempt small banks from the Volcker Rule, and asked if Quarles supported that exemption. Quarles declined to endorse a specific exemption, instead discussing how implementation of the rule has been needlessly costly. Quarles pointed out that repeal of Volcker is up to Congress.

Rep. Gwen Moore (D-Wis.) asked Quarles if he supported the Volcker Rule and other Dodd-Frank regulations. Quarles argued that the rules were not implemented effectively by regulators, and that regulators can improve the Volcker Rule by clarifying and simplifying the Rule and the definition of proprietary trading. Rep. Stephen Lynch (D-Mass.) pressed Quarles on a revision of Volcker, arguing that Congress’s intent to prohibit proprietary trading should preclude a regulatory definition that allows it. Quarles declined to provide detail on discussions between regulators on changes to the Volcker Rule, though he conceded that regulators could not repeal the rule because it is mandated by statute.

SIFIs
Rep. Keith Rothfus (R-Pa.) asked for a status update on rulemaking for the Financial Stability Oversight Council (FSOC)’s reviewing criteria for non-bank systemically important financial institutions (SIFIs), to which Quarles replied that he supports looking at an activities-based approach and that a rulemaking is “underway.”

Cybersecurity
Tipton asked about the Fed’s two-hour return to operations (RTO) proposal, noting that it is different from other domestic and international regulators. Quarles replied that the Fed has received comments on the proposal and will take them into account, but that given how important cyber resiliency is, the Fed thought this was an important issue.

Rep. Ann Wagner (R-Mo.) asked Quarles about the harmonization of cybersecurity regulations by financial regulators, and asked Quarles if it is “more important” for cyber staff at financial institutions to protect their infrastructure or answer questions in regulatory exams. Quarles said cyber staff should be focused on system resilience, not just compliance. Quarles pointed out that the Fed works with other agencies on cybersecurity examinations through interagency processes and through their participation in the FSOC.

Rep. Barry Loudermilk (R-Ga.) asked how the Fed is coordinating with other agencies regarding cybersecurity harmonization. Quarles replied that the Fed is focusing on “real resiliency” rather than pure compliance, and that the agencies are trying to “rejuvenate” the way they think about cybersecurity and where the real risk is.

Alternative Reference Rates

Rep. Robert Pittenger (R-N.C.) asked Quarles if the Fed has conducted a cost-benefit analysis regarding the economic impact on consumers and commercial borrowers from the transition away from the London Interbank Offered Rate (LIBOR) to the Secured Overnight Financing Rate (SOFR) in the U.S. Quarles noted that the Fed is not requiring the shift, but that the eventual end to mandatory LIBOR reporting necessitates the creation of viable alternatives, as failure to do so would impose costs on all market participants. Pittenger asked if the inclusion of repo transactions in SOFR would create systemic risks for the financial sector. Quarles said he does not believe this would create systemic risk. Quarles also said the Fed has considered the transition’s impact on regional and community banks and said that institutions will need to examine the costs of transition as the transition date approaches. 

Derivatives

Hultgren told Quarles he is concerned about the current exposure mechanism (CEM) in derivatives transactions, arguing that the CEM is insensitive to risk and hurts liquidity in large cap index options. Hultgren asked Quarles what steps short of notice-and-comment rulemaking the Fed could take to deal with the CEM’s harmful impact. Quarles said that a rule would be the most effective way to deal with the impact, but he agreed with Hultgren’s assessment on the costs the CEM creates for hedgers.

Community Reinvestment Act

Several members of the Minority asked about possible revisions to the regulations implementing the Community Reinvestment Act (CRA). In response to a question from Rep. Keith Ellison (D-Minn.) Quarles assured the committee that the Fed’s objective is to improve lending in capital starved and low-income areas, not to reduce it. Democrats were also broadly critical of the large number of financial institutions deemed in compliance of the CRA and the low number found to not be meeting their CRA requirements.  Several members also pressed Quarles on Home Mortgage Disclosure Act (HMDA) data that they argued showed discrimination in home lending in American cities.

Stock Buybacks

Some attention was paid to stock buybacks by the Minority at the hearing as well. Rep. Moore asked Quarles if he was concerned about stock buybacks harming the economy, and Quarles argued that buybacks are simply one way (among many) that firms return profits to stakeholders.

FINRA Rule 4210
Hill said that he does not believe the SEC has jurisdiction to regulate margin in agency securities, as that is a Fed prerogative, and expressed concern that FINRA Rule 4210 may create competition problems. Quarles agreed that regulations should not tilt the playing field for bank-owned dealers over non-bank affiliated broker dealers.

Base Erosion Anti-Abuse Tax
Hill noted that the base erosion anti-abuse tax (BEAT) found in the new tax reform bill appears to conflict with the financial services policies on Total Loss Absorbing Capital (TLAC) and asked for Quarles thoughts. Quarles said he is familiar with the issue and that he has spoken with banks and asked them to quantify the BEAT, though it is taking some time for the estimates to come in. He stated that the Fed and Treasury are discussing whether this should be potentially addressed through a Treasury rulemaking or Fed regulatory policy.

Living Wills
When asked by Hensarling if the Fed is considering having the annual living will process be less frequent, Quarles replied that the Fed is able to make this change and that it may be appropriate to do so now. As a follow up, Hensarling asked if the Fed would publicly disclose the assessment framework (as suggested in Section 165 of the Dodd-Frank Act and H.R. 4292, which passed the House floor in a 414-0 vote) and how long it would take to do so, to which Quarles replied it could possibly be done within a six month period.

For more information on this hearing, please click here.