Fed’s Quarles, FDIC’s McWilliams Outline Potential Reforms to Bank Supervision

On December 11, 2020, US Federal Reserve Board (“Fed”) Vice Chair for Supervision Randal K. Quarles¹ and US Federal Deposit Insurance Corporation (“FDIC”) Chairman Jelena McWilliams² each outlined potential reforms of the bank supervisory process currently under consideration at their respective institutions. Vice Chair Quarles and Chairman McWilliams delivered their remarks at a conference on bank supervision co-sponsored by the Fed, Harvard Law School and the Wharton School of the University of Pennsylvania. In this Legal Update, we highlight key reforms discussed by Vice Chair Quarles and Chairman McWilliams.

Fed Vice Chair Randal K. Quarles

In his keynote address, Vice Chair Quarles outlined a vision to reform supervision through simpler, more consistent, more predictable and more efficient supervisory standards. He noted the success the Fed has had in implementing these standards with respect to regulation when it created its new regulatory framework following the 2008 financial crisis, which he maintained helped ensure that banks had the financial capacity to not only weather the COVID-19 shock, but continue to lend throughout the economic downturn. He recognized that applying these principles to supervision is more difficult. However, he pointed out the consequences that the supervisory process, especially supervisory ratings decisions, can have on institutions, including determining whether they can engage in important activities (such as securities and insurance underwriting) and  acquisitions. Given these consequences, he argued that it was critical to get ratings correct. To do so, he stated that the Fed needs to bring science to its ratings process, noting that the Fed does not have a good theory of ratings and that there are few empirical studies on the value of ratings or where rating cutoffs should be made.

Vice Chair Quarles proposed several potential reforms for improving supervisory ratings. He said that the Fed could:

• Simplify the RFI rating system (applicable to less-systemic holding companies) and the CAMELS rating system (applicable to depository institutions) by reforming them to reflect the new, more streamlined LFI rating framework (applicable to large institutions). The simplified LFI rating framework focuses on the three areas that are the core of the Fed’s supervisory focus (capital, liquidity and governance) and does not assign a composite rating to an institution.
• Explore approaches to ratings that yield more consistent ratings across institutions and over time, such as (i) subjecting ratings to the scrutiny of a committee-type system representing a range of perspectives and experiences (similar to the process currently used by credit rating agencies), and (ii) dedicating a portion of examinations to reviewing compliance with concrete regulatory standards, and committing in advance to giving the findings from these reviews a particular weight in ratings discussions.
• Invite public feedback on guidance or other supervisory standards applicable to institutions, which will improve the predictability of ratings.
• Encourage the Fed’s examiners and economists to conduct more empirical analysis around supervisory ratings that focuses on two main variables: (i) the consequences of the ratings—for example, a firm having its activities or acquisitions curtailed—and (ii) whether or not these consequences are properly calibrated relative to the circumstances that gave rise to the rating.

As a next step in reforming supervision, Vice Chair Quarles stated that he has directed the Fed staff to research three specific issues that reflect several (though not all) of the changes proposed in his speech. These three issues are:

(1) The appropriate role of qualitative elements, which allow for somewhat more discretion in application relative to quantitative regulatory requirements, in the ratings frameworks (e.g., whether qualitative ratings elements should be placed in quantitative-focused components, such as capital and liquidity);

(2) The relative weights between qualitative and quantitative elements of the rating; and

(3) A comparison of the new LFI rating framework and the RFI rating framework.

Vice Chair Quarles did not indicate a timeframe for either the Fed staff to report back on their research or the Fed to formally propose any of the reforms discussed in his remarks. However, it is clear that Vice Chair Quarles has started a process that could lead to substantial changes to the Fed’s supervisory process. Given that Vice Chair Quarles has less than a year remaining in his term as Vice Chair, however, it is reasonable to expect reform proposals sometime in 2021.

FDIC Chairman Jelena McWilliams

In her remarks, Chairman McWilliams highlighted the FDIC’s ongoing efforts to improve supervision in both: (i) the immediate term through reforms to increased transparency, certainty and consistency, and communication in supervision; and (ii) in the longer term through a transition to a “continuous engagement” approach to supervision.

Chairman McWilliams discussed the FDIC’s efforts to improve the agency’s supervision in the near term through adjustments to its processes and regulations. With respect to improving the FDIC’s transparency in supervision, she pointed to its publication of performance metrics on examinations and charter applications. With respect to improving certainty and consistency, she pointed to the FDIC’s rule proposal to codify the 2018 interagency statement that institutions would not be criticized for “‘violations’ of supervisory guidance, but only for violations of law, regulation, or non-compliance with enforcement orders or other enforcement conditions.”³ With respect to improving communication in supervision, she pointed to the FDIC’s proposal to establish a new Office of Supervisory Appeals to resolve disagreements in an examination. The Supervisory Appeals Office would be a stand-alone unit in the FDIC and would be staffed by externally recruited personnel (such as former bank examiners). Chairman McWilliams also noted that the recently established Subcommittee on Supervision of the FDIC’s Advisory Committee on Community Banking has already provided useful feedback.

Chairman McWilliams said that the FDIC will seek to develop what she described as a “continuous engagement” approach to supervision that would shift the FDIC’s historic approach of static, point-in-time assessments to more routine, informal engagement and analysis. This modernized approach would allow regulators to see “dashboard”-style views of an institution’s financial health using data that is more granular and made available more frequently than current reporting. Eventually this approach could serve as a substitute for the Call Report and reduce the burdens imposed by onsite examinations. The FDIC has already selected 15 technology companies to participate in a competition to develop in 180 days a prototype technology that would provide the FDIC with more timely and granular data on its regulated banks, while also reducing the compliance costs for adopting banks. Chairman McWilliams was careful to note that the intention was not to create a “real-time monitoring” system, as such a system would not only be intrusive to community banks, but also waste the FDIC’s resources. Further, she stated that institutions would have to choose to “opt in” to this supervisory approach.