Randal K Quarles: The importance of transparency, accountability,
and fairness in regulation
Speech (via webcast) by Mr Randal K Quarles, Vice Chairman for Supervision of the Board of
Governors of the Federal Reserve System, at the Hoover Institution, Stanford, 14 October 2020.
* * *
I want to thank John Taylor and the Hoover Institution for inviting me to speak today. I will start
with some brief remarks about the current economic situation and monetary policy and then turn
to the actions that the Federal Reserve has taken this year to help ensure that the banking
system remains a source of strength during the recovery from the COVID event, the term I use
for the complex set of responses in both the private and public sectors to the outbreak of
COVID19. I will close with some thoughts on nonbank financial institutions and international
coordination.
Although the COVID event put the U.S. economy in a deep hole, the recovery since the economy
began reopening in May has been stronger than almost any forecaster predicted back in the
spring. Spurred in part by record fiscal stimulus, both business and household spending appear
to have bounced back significantly through the third quarter, and we have regained about half of
the jobs lost in March and April.
I attribute a good portion of that strength to the inherent dynamism and flexibility of the American
economy. Although the COVID event continues to stress businesses, many businesses adjusted
their operations to remain open, and applications for new businesses surged over the summer.
Meanwhile, better treatments and more-targeted containment measures focused on protecting
the most vulnerable have resulted in falling rates of hospitalization and mortality. Therefore, I am
optimistic that the recovery from the COVID event will continue to be robust.
Of course, while we're doing better than expected, we still have a ways to go. The labor market
remains deeply depressed, and employment is far short of the Federal Reserve's maximum
employment goal. We are also keenly aware that the harm from higher unemployment has fallen
even more than usual on those low-income households least able to bear it. Some businesses,
particularly those in high-contact and personal-service industries, largely have been left out of the
recovery. Inflation is well below our 2 percent longer-run goal, and some measures of inflation
expectations have ticked down.
Therefore, at the September Federal Open Market Committee (FOMC) meeting, I voted in favor
of the new and clearer forward guidance for monetary policy because it will provide additional
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support for the recovery. Indeed, interest-rate and credit-sensitive sectors-business spending,
home sales, auto sales, and other "big-ticket" items-have helped fuel that recovery. This
spending was supported by our timely and forceful moves to cut the federal funds rate to its
effective lower bound, restore market functioning, and provide emergency support to households
and businesses through 13(3) emergency lending facilities.
Which leads me to the banking industry. For monetary policy to fully support Main Street, we
need a well-capitalized, stable banking system that is lending to creditworthy households and
businesses. Since the Global Financial Crisis (GFC), the Federal Reserve has focused on
building the resiliency of banks so that they would be a source of strength during the next
downturn. Thus far, that plan has borne a great deal of fruit.
As the crisis intensified in early March, banks stepped into the breach and met the massive
demands for cash from businesses that drew on their preexisting credit lines. Banks also funded
the bulk of the more than $500 billion in Paycheck Protection Program (PPP) loans. According to
our weekly bank credit data, commercial and industrial loans increased $715 billion between the
week of February 26th and their peak on May 13th. For millions of struggling households, banks
have agreed to forbear interest and principal payments on their loans. In addition, through
September, banks absorbed more than $1.2 trillion of central bank reserves and received about
$2.5 trillion of core deposits from investors who sought the safe haven of the U.S. dollar and
insured bank accounts.
As supervisors, we recognized that these actions strained the balance-sheet capacity of banks
and so have taken a number of steps to allow them to continue to support their customers during
this unprecedented time. A number of those steps-such as encouraging banks to work with
their customers until the emergency subsides-are consistent with what we do whenever there
is a natural disaster that disrupts normal commerce. But the COVID event has affected the entire
country at the same time, requiring a broad set of extraordinary actions. For instance, we have
temporarily exempted reserves and Treasury securities from the Supplementary Leverage Ratio
so that banks do not become constrained by growing Treasury issuance and central bank
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reserves and can support businesses and households. More broadly, we have reintroduced and
added numerous funding facilities through our 13(3) authority to support the continued flow of
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credit in the economy.
Throughout all this, U.S. banks have remained financially healthy. Second-quarter data showed
that most banks were profitable, aggregate capital ratios increased, and banks continued to
maintain ample levels of liquidity. In addition, banks added substantially to their loan loss reserves
over the first half of 2020, providing additional resilience. This week, some of the largest
institutions have begun to report that their profitability held up again in the third quarter, partly
because their robust provisions for loan losses earlier this year limited the need for additional
provisions this quarter.
Going forward, we will want to be sure that banks remain a source of strength and support for the
economy. Even with the economic recovery being stronger and faster than expected, there are
certainly reasons to be vigilant. Interest rates are likely to remain very low for quite some time,
putting downward pressure on banks' net interest margins and their profitability more generally.
The high level of corporate debt and elevated valuations in commercial real estate going into this
crisis, combined with prolonged uncertainties and changes in the way we shop and work, could
lead to higher-than-expected losses on loans to some of these businesses. Consumer lending
and residential mortgages seem to be holding up well so far, which may reflect the relatively high
quality of household credit going into the COVID event. However, the performance of these loans
also needs to be watched closely in light of the forbearance policymakers have encouraged and
the possibility of a reduction in fiscal support for households.
For the past decade, robust stress testing has been at the core of our strategy for ensuring that
our largest banks have sufficient capital to meet the credit needs of their customers while
weathering an extreme downturn. In making decisions about our stress tests this year, I have
been guided by three principles: First, we want to make sure that our supervisory and regulatory
actions do not exacerbate the fallout from what was the most extreme deterioration in economic
conditions on record. Second, we want to jealously guard the credibility of our stress tests, which
restored confidence in banks during the GFC and have helped maintain that confidence since.
Third, we want to establish the precedent that our response to a crisis would remain as
deliberate, data driven, and bank specific as could be done prudently.
Therefore, once it was apparent that our initial stress test scenarios for 2020-which were
released before the pandemic-had been overtaken by events, we conducted a suite of
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additional analyses to assess the sensitivity of this year's results. This comprehensive analysis
included consideration of banks' vulnerabilities under three additional downside scenarios that
were very severe even given how gloomy the picture looked this spring. The staff also
incorporated a number of conservative assumptions about the balance sheet changes that we
saw at the end of the first quarter.
This analysis found that the banking system would experience substantial losses under those
highly adverse conditions but remain well capitalized in the aggregate. However, individual bank
outcomes across the three scenarios varied significantly. The variation in those outcomes
highlighted the considerable uncertainty in the economic outlook at the time and how that would
translate to banking conditions in coming quarters.
Accordingly, we required banks to resubmit their capital plans and took several actions to
preserve capital in the interim. For the third quarter, the Board required large banks to suspend
all stock repurchases, capped their dividends, and placed a second limit based on individual
banks earnings. The limitation of share repurchases, which accounted for 70 percent of all
capital distributions at large banks in recent years, by itself led to a meaningful preservation of
capital among large banks. The dividend restrictions guarded against capital depletion in the
event that some banks experienced unexpectedly large losses, while still allowing firms that
could support them to pay out dividends. Late last month, the Board extended the distribution
limitations onto the fourth quarter amid the continued uncertainty. The Federal Reserve is
currently conducting another round of stress tests, using two new severe downside scenarios
published last month, and will release bank-specific results from both scenarios before the end
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of the year.
Taken together, these actions will preserve capital in the system during this highly uncertain time.
As I noted, I also hope that the process we followed to arrive at these decisions will affirm that
our actions, even in a crisis, will be dictated by the most comprehensive analysis we can do in a
timely manner and will be as tailored to individual institutions' condition as is feasible given the
circumstances.
While banks so far have been resilient to the shock from the COVID event, the same cannot be
said for important parts of the system of nonbank financial intermediation (NFBI). Starting in
March, Federal Reserve facilities were needed to contain pressures in some prime money
market funds, as well as, to a lesser extent, in certain long-term mutual funds that invest in
corporate debt. Other types of NBFI also struggled during that period, including nonbank
mortgage servicers and real estate investment trusts, the latter of which received support from
the Board's decision to, for the first time, purchase agency commercial mortgage-backed
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securities.
The vulnerabilities of NBFI are also at the top of the mind of international regulators. The Financial
Stability Board's (FSB) annual report on NBFI indicates that the NBFI sector is now almost 50
percent of total financial intermediation, and many NBFIs rely on the banking system for credit
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and backstop liquidity. Thus, late last year, I formed a high-level steering group of central
bankers, market regulators, and international organizations to oversee the FSB work on nonbank
finance and to help coordinate work across the range of global standard setting bodies that
oversee the financial sector. The group is currently completing a holistic review of the COVID
event to better understand the role that vulnerabilities stemming from the NBFI sector played in
those events. In the wake of the COVID event, we have made good progress in arriving at a
shared diagnosis of the market turmoil that happened during the onset of the event in March.
Our discussions have surfaced a number of issues associated with particular types of market
participants and mechanisms that may have caused liquidity imbalances and propagated stress.
They include: vulnerabilities in money market funds (as I discussed earlier); dealers' capacity and
willingness to intermediate; market structure in the core government bond markets and,
potentially, the role of leveraged investors; and fragilities in US dollar cross-border funding.
We are looking at the role that each of these factors may have played, but we are not yet
prepared to say "J'accuse" to any one of them. This is because our work has also reinforced the
point that one needs to examine the system as a whole and take into account the various
linkages within nonbank financial intermediation and between nonbanks and banks.
We will provide to the G20 Summit next month our holistic review of the turmoil and a concrete
set of proposals for follow-up work on NBFI. This will provide a basis for a work plan for 2021,
focused on better understanding this critical sector, vulnerabilities related to it, and how we might
take a more macroprudential approach to supervising and regulating at least some parts of this
sector.
Thanks again to the Hoover Institution for having me, and I look forward to the discussion that
follows.
1
Board of Governors of the Federal Reserve System, "Federal Reserve Issues FOMC Statement," press release,
September 16, 2020. Return to text
2
"Assets and Liabilities of Commercial Banks in the United States - H.8," last modified October 9, 2020. Return
to text
3
Board of Governors of the Federal Reserve System, "Federal Reserve Board Announces Temporary Change to
Its Supplementary Leverage Ratio Rule to Ease Strains in the Treasury Market Resulting from the Coronavirus
and Increase Banking Organizations' Ability to Provide Credit to Households and Businesses," press release,
April 1, 2020. Return to text
4
"Coronavirus Disease 2019 (COVID-19)," Board of Governors of the Federal Reserve System, last modified,
April 30, 2020. Return to text
5
Board of Governors of the Federal Reserve System, Assessment of Bank Capital during the Recent Coronavirus
Event (PDF) (Washington: Board of Governors, June 2020). Return to text
6
Board of Governors of the Federal Reserve System, Supervisory Scenarios for the Resubmission of Capital
Plans in the Fourth Quarter of 2020 (Washington: Board of Governors, September 2020). Return to text
7
Board of Governors of the Federal Reserve System, "Federal Reserve issues FOMC statement," press release,
March 23, 2020. Return to text
8
Financial Stability Board. "FSB Publishes Annual Report on Nonbank Financial Intermediation," press release,
January 19, 2020. Return to text