With a focus on pragmatic and risk-based oversight, new leadership at the Federal Reserve signals a shift in the regulatory landscape for U.S. banks. Earlier this month, the Senate confirmed Federal Reserve Governor Michelle Bowman as the next vice chair for supervision at the Federal Reserve. Bowman, who was nominated by President Trump in March, will have considerable influence over the banking industry in her new position. The vice chair for supervision oversees the regulatory framework for U.S. financial institutions.
Bowman has been on the Fed’s Board of Governors since 2018. She succeeds Michael Barr, a Biden nominee, as supervisory vice chair.
Pragmatism in Regulation
Bowman’s agenda will focus on reforming the current regulatory framework, paring back many regulations and pursuing a more pragmatic set of rules that, according to Bowman, focus on addressing core and material financial risks, remain grounded in applicable law and provide clear standards to the regulated banks.
In a speech she delivered on June 23 at the Annual International Journal of Central Banking Research Conference in Prague, Bowman spoke in detail about the importance of creating financial regulations that are more dynamic in nature, with a focus on giving significant consideration to the ongoing shifts in the economy and in financial systems and activity as a whole, to craft monetary policy that takes into account the evolution of these financial systems.
Bowman also acknowledged that, although her role, and the role of the Federal Reserve as a whole, is primarily focused on the banking system, the effects of banking regulations have a much broader impact. It is that impact, according to Bowman, that should be an important consideration in the Fed’s regulatory requirements. Therefore, in Bowman’s view, the Fed’s job in regulating the banking industry requires a much wider economic analysis in order to promote U.S. financial stability.
Revisiting the Leverage Ratio Rules
Treasury Market Liquidity Under Pressure
The Federal Reserve has reviewed data related to the performance of the U.S. Treasury market and identified issues with market liquidity that are preventing the market from functioning smoothly. Although the Securities and Exchange Commission has recently made some changes to the central clearing requirements for U.S. Treasuries, Bowman has indicated that these changes may not be enough to keep the U.S. Treasury market afloat in the face of a future stress event.
Why the eSLR Is Under Review
In order to keep the largest bank-affiliated primary dealers from experiencing undue pressure from banking regulations, Bowman has identified the supplementary leverage ratio requirements currently in place as in need of immediate revision. In “recalibrating” the leverage capital requirements, essentially lowering the enhanced supplementary leverage ratio (the “eSLR”) applicable to the largest banks, Bowman’s stated goal is to reduce the restrictions on bank-affiliated broker-dealers, especially as they engage in low-risk activities like those associated with U.S. Treasuries.
Fed’s Proposal: No Return to the COVID-Era Exemption
On June 24, only a day after Bowman’s speech in Prague, Federal Reserve Chair Jerome Powell announced to the U.S. House Financial Services Committee that the Fed’s changes to the eSLR will not restore the COVID-era exemption to eSLR that allowed banks to exempt U.S. Treasuries from their calculation of eSLR. Instead, on June 25, the Fed issued an initial proposal that “recalibrates” the eSLR requirement.
Key Changes Under the Proposal:
Under the existing eSLR rule, global systemically important banks (“GSIBs”) must maintain a capital buffer of 2% for bank holding companies and 3% for depository subsidiaries; these are in addition to an existing 3% minimum leverage ratio.
Under the new proposal, the capital buffers that apply to GSIBs would be tied to their method 1 scores (which measures a bank’s systemic importance and is updated annually); all GSIBs would be required to maintain capital buffers under the eSLR rule equal to half of their method 1 capital surcharge. Because method 1 surcharges can be anywhere between 0.5% and 2.5%, the new proposal represents a potentially significant reduction in the eSLR applicable to a GSIB, requiring banks to maintain lower reserves to meet leverage ratio requirements.
Implications for the Treasury Market and Banks
This, in turn, Powell argued, will achieve the desired result of encouraging more engagement with low-risk intermediation by freeing up capital that would otherwise be held by banks to meet eSLR requirements. And with more large banks increasing their Treasury market intermediation, the U.S. Treasury market will experience increased stability, thus improving an area of primary concern to the Federal Reserve that would have a positive effect on overall US economic health. In addition, because the eSLR requirements are now specifically tied to a bank’s method 1 score, it represents a more dynamic capital buffer requirement that is linked to the risk profile of each individual GSIB and updated annually to account for changes relative to each bank.
Other Potential Changes on the Horizon
Shortly after her Senate confirmation, Bowman spoke in Washington, D.C., where she gave a preview of her plans. Given that we are already seeing the Fed take action to reform one of the key areas of regulatory policy identified by Bowman, additional changes are likely forthcoming in other areas she has frequently mentioned.
Included in the potential changes:
- Scaling back the Basel III endgame proposal (which would have raised capital requirements for the largest banks)
- Reducing proposals for expanding long-term debt requirements for banks
- Large scale changes to the Fed’s stress-testing process, which have recently come under fire in a lawsuit filed by major banking trade groups
- Tailoring the supervisory and regulatory framework applicable to different banks based on size; thresholds related to qualifying as a small community bank may increase
- Revisiting supervisory ratings for banks to more accurately reflect potential risk; accounting for multiple factors in calculating larger bank ratings, and the revisiting the separate framework used for rating smaller banks to “capture material financial risks”
- Requiring more Fed staff members to become commissioned examiners, allowing for less emphasis on procedural checklists and other examiner guidance, and giving examiners more flexibility in considering the full picture of a bank’s financial health
Takeaways for Lenders and Businesses
The release of yesterday’s proposal by the Federal Reserve represents both a significant change in capital requirements for large banks and a meaningful shift in the Fed’s approach to banking regulations. The speed at which Bowman’s initial proposals have been put into action, as well as the fact that the proposal received approval by both Republican and Democrat members of the Federal Reserve Board of Governors, indicate that more changes to Fed policy will be soon approaching, most likely aimed at improving US economic health and more closely tailoring regulations to address banks’ risk profiles.
While there is no guarantee that we’ll see a jump in Treasuries activity, a significant uptick in bank activity in the months to come is a likely outcome, as banks are able to repurpose the additional headroom from the Fed’s proposal to increase their market presence.
Questions about how these changes could affect your business or lending activity? Contact KJK Commercial Finance & Banking partner Jessica Wiedemann at 216.736.7214 or JLW@kjk.com.
