For release on delivery
6:45 p.m. EST
March 5, 2024

Tailoring, Fidelity to the Rule of Law, and Unintended Consequences

Remarks by
Michelle W. Bowman
Member
Board of Governors of the Federal Reserve System
at the
Harvard Law School Faculty Club

Cambridge, Massachusetts

March 5, 2024

Thank you for the invitation to join you this evening at Harvard Law School.' It is an
honor and a pleasure to speak to this distinguished group. To kick off our conversation, I would
like to frame the discussion by offering my views on a key element underpinning the U.S. bank
regulatory framework: the role of tailoring. While the principle itself is simple-setting
regulatory priorities and allocating supervisory resources in a risk-based way-the consequences
of tailoring (or not) can reverberate throughout the banking system, the broader U.S. financial
system, and the economy. I see a clear nexus between tailoring and fidelity to the law, including
a targeted focus within our statutorily mandated prudential responsibilities.

Tailoring as a Grounding Principle

I have long been a proponent of tailoring and continue to consider it a strong foundational
principle upon which to apply bank regulation and supervision. This approach ensures a focus
on the most critical risks over time, avoiding the over-allocation of resources or imposition of
unnecessary costs on the banking system. When we approach rulemaking with a commitment to
tailoring, and to our broader prudential mandates, the public can judge our actions by how well
they serve these ends, and they should rightly be concerned when regulatory actions seem to
serve other goals. In this sense, tailoring keeps policymakers grounded and facilitates
appropriate prioritization. Tailoring also allows us to allocate limited supervisory resources to
most effectively support safety and soundness of the banking system and U.S. financial stability.

In accordance with the law, the Federal Reserve, both in its monetary policy function and
in the execution of its bank regulatory and supervisory responsibilities, is meant to operate

independently and apolitically. But banking regulators have a responsibility to act in a way that

' The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market
Committee or the Board of Governors.

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proves this independence is warranted. We earn the right to operate with this independence
when we consistently follow the law and achieve our prudential objectives. One of the most
effective ways we accomplish this goal is through the appropriate prioritization of risks in the
financial system. Regardless of the approach to bank regulation and supervision, bank regulators
should be subject to oversight and accountability, to both Congress and the public.

The principles that guide the execution of prudential responsibilities matter, especially
when they further efficiency and effectiveness. Congress has embedded the concept of tailoring
within the Federal Reserve's regulatory mandates, including the Economic Growth, Regulatory
Relief, and Consumer Protection Act, commonly referred to as S. 2155.? This law revised
provisions of the Dodd-Frank Act, amending the threshold for tailored application of enhanced
prudential standards on certain regulated institutions.* Notably, S. 2155 did not introduce
tailoring to these standards; it merely modified tailoring thresholds and mandated the Board
implement this approach. To be clear, tailoring is not a pretext for deregulation but rather a
principle that allows regulators to pursue required statutory objectives in the most efficient and
effective way.

Does Tailoring Need a Defender?

I suppose one could view my support for tailoring as merely setting up a straw man;
surely everyone agrees with tailoring in principle? On a superficial level, it is hard to argue with
the principle that regulatory tailoring-matching regulation and supervision to risk-is a prudent
approach for bank regulators. And yet the rhetoric supporting tailoring and risk-based

supervision often does not match regulatory reform efforts or supervisory approaches. The

? Economic Growth, Regulatory Relief, and Consumer Protection Act, Pub. L. No. 115-174, 132 Stat. 1296 (2018).
3 Pub. L. No. 115-174, § 401(a)(1), amending 12 U.S.C. § 5365.

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criticisms rarely manifest as skepticism of the principle itself. Rather, they are implicit in the
approach to regulation and supervisory guidance or are disguised as a criticism of the execution
of tailoring.

Both the pending capital reform proposals and the final climate guidance illustrate how
regulatory actions can deviate from the principle of tailoring without any express recognition of
this effect.

The federal banking agencies have proposed several reforms to the capital framework,
among them the Basel III "endgame" and new long-term debt requirements that would apply to
all banks with over $100 billion in assets. I have expressed concern with both of these proposals
on the merits, in terms of striking the right balance between safety and soundness and efficiency
and fairness, and out of concern for potential unintended consequences. Another concern is
whether these proposals show fidelity to the law, which requires regulatory tailoring above the
$100 billion asset threshold. In 2019, the Board published its regulatory tailoring rule and
included a compelling visual that depicts in table form how a series of requirements-capital,
single counterparty credit limits, liquidity, and the requirement to form a U.S. Intermediate
Holding Company for foreign banking organizations-worked collectively to establish a tiered

framework.

4 See Tailoring Rule Visual, "Requirements for Domestic and Foreign Banking Organizations," October 10, 2019,
https://www.federalreserve.gov/aboutthefed/boardmeetings/files/tailoring-rule-visual-20191010.pdf.


Capital

Single-counterparty credit
SCCL SCCL
sccr [SERENE + BHCMIHC level SCCL + BHCMHC level SCCL cory oe
« FBOs: Meet home country I I ¢ FBOs: Meet home country I I* melee OMe Loup CEES? [IC LEE ee pie COREY.
« FBOs: Meet home country s . requirement if global requirement if global
5 requirement requirement
requirement assets>$250B assets=>$250B
Standardized
Liquidity I Standardized Standardized « If wSTWF <$75b: Standardized
Golding I * Full daily LOR (100%) © Full daily LCR (100%) Reduced daily LCR and * If wSTWE < $50b: No
eae © Proposed full daily NSFR+ I I © Proposed full daily NSFR{ I I NSERf (85%) LCR
(100%) (100%) ¢ If wSTWE = $75b: Full ¢ If wSTWE = $50b:
daily LCR and proposed Reduced monthly LCR and
NSER{ (100%) proposed NSFR{ (70%)
orting
* Report FR 2052a daily
Liquidity Reporting
ry * Report FR 2052a monthly
Operation)
Pi U.S. IHC Requirement U.S, THC Requirement U.S. THC Requirement U.S. IHC Requirement U.S. IHC Requirement

Requirements for Domestic and Foreign Banking Organizations*

Category I

U.S. GSIBs

Category IT

> $700b Total Assets or
> $75b in Cross-
Jurisdictional Activity

Category III

2 $250b Total Assets or
> $75b in nonbank assets,
wSTWF, or off-balance
sheet exposure

Category IV

Other firms with $100b to
$250b Total Assets

Other Firms

$50b to $100b Total Assets

TLAC/Long-term debt

* Certain requirements for a foreign bank are determined by the risk profile ofits intermediate holding company, whereas other
requirements are determined by the risk profile of the firm's combined U.S. operations. Capital and standardized liquidity
standards are determined by the risk profile of the intermediate holding company and other standards are determined by the risk
profile of the firm's combined U.S. operations. Other foreign banks with limited U.S. presence and global assets of $100 billion
or more would be subject to certain minimum standards.t The proposed net stable funding ratio (NSFR) rule will not be
finalized as a result of the tailoring final rule.

Glossary. wST WF - weighted short-term wholesale funding; HCs -bank, savings and loan, or intermediate holding company;
CUSO -- combined U.S. operations, AOCI - accumulated other comprehensive income; CCAR - Comprehensive Capital
Analysis and Review, LCR - liquidity coverage ratio.

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If you superimpose the pending capital reform proposals on the table, there is a
"flattening" of requirements in the capital bucket. Of course, this simple exercise does not
reflect the unknown end state of the bank regulatory framework, and the current desire among
some policymakers to modify liquidity requirements. These individual efforts highlight the
hazard of piecemeal reforms, especially those that are closely related in their end-state operation,
like capital and long-term debt requirements. When regulators pursue reforms by creating
separate rulemaking silos, we limit our capacity to not only ensure fidelity to tailoring but also
fidelity to our prudential mandates. Even when proposals have concurrent comment periods, the
danger is that the final regulations will be miscalibrated and not appropriately tailored.

Tailoring underpins not only effective regulation, but also effective bank supervision.
The effectiveness of the interagency principles used by the Federal Reserve, the Federal Deposit
Insurance Corporation, and the Office of the Comptroller of the Currency for the management of
climate-related financial risks could be evaluated as a supervisory tool through the lens of
tailoring, which requires us to consider both the regulatory threshold for applicability and the
content of the guidance.* One approach to evaluate the merit and effectiveness of these
principles as a supervisory tool is through the lens of tailoring, which requires us to consider
both the regulatory threshold for applicability and the content of the guidance.

On its face, it applies to banks with $100 billion or more in consolidated assets. What
does this threshold mean in practice? Guidance serves the role of illuminating supervisory
priorities and expectations. These informal communications help bridge the divide between

regulators and regulated entities. When guidance notes that "all financial institutions, regardless

5 Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the
Comptroller of the Currency, "Agencies Issue Principles for Climate-Related Financial Risk Management for Large
Financial Institutions," news release, October 24, 2023,
https://www.federalreserve.gov/newsevents/pressreleases/bcreg20231024b.htm.


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of size, may have material exposures to climate-related financial risks. ..,"° my intuition is that
banks will take little comfort from the nominal carveout in light of this language. Apart from the
general concern with the "cliff effect" threshold at $100 billion, I question whether any size
threshold will apply in practice.'

The content of the guidance-and its expectations for larger banks-suggests that the
motivation behind the principles is neither prudential considerations nor to further regulatory
tailoring, as it has a somewhat tenuous connection to core safety and soundness considerations
and seems destined to trickle down to smaller firms over time. Banks have long been exposed to
climate- and weather-related financial risks and have long been required to manage all of their
material risks, including these. But the principles seem oriented toward contributing to a policy
matter that extends well beyond prudential bank regulation-namely how the U.S. and other
governments around the world should address climate change. And the principles seem focused
on highly uncertain risks well outside the normal temporal horizon of a bank supervisor. One
could reasonably ask, do the principles result in appropriate, risk-based prioritization of
supervisory concerns? It is possible that they prioritize risks that may not be the most relevant
for safety and soundness and may effectively influence credit allocation decisions through
regulations that are not driven primarily by prudential considerations.

Bank regulators can acknowledge the importance of questions around climate change
while also hewing to their statutory responsibilities. Promoting safety and soundness and U.S.

financial stability is a weighty enough task without taking on other causes.

© 88 Fed. Reg. 74,183-184 (October 30, 2023).

7 See Michelle W. Bowman, "Reflections on the Economy and Bank Regulation" (speech at the Florida Bankers
Association Leadership Luncheon Events, Miami, Florida, February 27, 2024),
https://www.federalreserve.gov/newsevents/speech/files/bowman20240227a.pdf.


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The current regulatory agenda includes many other examples where similar arguments
can be made that regulatory reform proposals lack sufficient attention to regulatory tailoring and
thereby fail to further statutory directives to tailor certain requirements and, more importantly, to
address the condition of the banking system.

Apart from substantive deviations from regulatory tailoring, there are also indirect attacks
on the value of tailoring as a principle to guide bank regulatory reforms. For example, one
prominent argument raised shortly after the failure of Silicon Valley Bank, and which has
become a driving force in regulatory reform efforts, is that the Board's approach to tailoring was
to blame for the bank failures and broader banking stress.* The argument is that a major factor
contributing to the bank failures was the implementation of S. 2155, the statutory mandate to
tailor regulation and an accompanying shift in supervisory policy.

As I have noted many times in the past, I find little evidence to support this claim. While
couched as a critique of the execution of tailoring, this argument also seems to challenge the
value of tailoring, asserting that a simple solution would be to unwind regulatory tailoring and
eliminate risk-based tailoring in supervision. Taking ownership and accountability of the
supervisory issues that significantly contributed to the banking system stress last spring enables
us to look critically at the approach to regulation and supervision in the lead-up to these failures,

and appropriately address the shortcomings.

8 See Board of Governors of the Federal Reserve System, "Review of the Federal Reserve's Supervision and
Regulation of Silicon Valley Bank," (Washington: Board of Governors, April 2023), introductory letter by Michael
S. Barr, https://www.federalreserve.gov/publications/files/svb-review-20230428.pdf (concluding that "[t]he Board's
tailoring approach in response to the Economic Growth, Regulatory Relief, and Consumer Protection Act
(EGRRCPA) and a shift in the stance of supervisory policy impeded effective supervision by reducing standards,
increasing complexity, and promoting a less assertive supervisory approach.").


Why Does Tailoring Matter?

Before thinking about tailoring for smaller, simpler firms, I think it's helpful to think
about the largest, most complex firms. Additional regulation and heightened supervisory
attention are warranted and necessary for larger firms, particularly global systemically important
banks (GSIBs) with additional size, risk, and complexity. This principle is so well-established
that it was not only a core precept of S. 2155, it was a central theme of the Dodd-Frank Act.? We
need not rely on past views about the virtue of tailoring-what was once conventional wisdom-
to believe in its ongoing relevance.

One critique of tailoring may be with what underlying "problem" it is designed to solve,
particularly as it relates to the allocation of finite resources both for banks and for regulators.
Are regulatory and supervisory resources actually limited, and if so, what are the practical
constraints on these resources? At a basic level, the quantum of regulatory and supervisory
resources is a policy decision-as regulatory and supervisory demands grow, so too can the
staffs and budgets of the federal banking agencies. The U.S. financial system is expansive and
regulators have the capacity to expand supervisory resources as needed (or as perceived) to
address safety and soundness concerns.

Of course, there are practical constraints on an ever-expanding and stricter bank
regulatory framework. First, the funding of regulatory and supervisory expansion imposes costs
not only on U.S. taxpayers but also on banks, and indirectly, bank customers. While the banking
system has many advantages- including the use of insured deposits as a source of financing
banking activities-at some point, this structural advantage will erode under the cumulative

burden of the regulatory framework and will result in a shift of activities from banks to nonbanks

° Pub. L. No. 111-203, 124 Stat. 1376, 1423, § 165 (July 21, 2010).

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and the broader shadow-banking system. The contours of the financial system, where products
and services are offered, does not exist according to the bright line of federal regulatory
authority. We would be well served to recognize the limitations of a regulatory perimeter that
pushes activity outside of the banking system and beyond this authority.

Unintended Consequences

As we consider the merits of tailoring, we should consider the consequences of not
adhering to this principle in regulation and supervision, and related reform proposals.

As a threshold matter, a bank regulatory approach that disregards tailoring can manifest
in different ways, such as uniformity in approach-failing to differentiate among institutions
based on their size, risk, and complexity-or by adopting regulatory "cliffs" clustered around
thresholds that insufficiently distinguish among institutions based on these factors. In both
cases, deviating from tailoring could result in fundamental changes to the structure of the U.S.
banking system.

One risk of uniform requirements is the consolidation pressure it creates. Apart from the
shortcomings I've discussed in appropriate risk-based prioritization within the bank regulatory
framework, this approach encourages consolidation, as institutions seek operational economies
of scale to gain competitive advantage over their peers. In this scenario, the benefits of being
large, risky, and complex become a driving force in the organization of the banking industry. I
think we should consider the implications not only for regulatory efficiency, but also whether
this approach represents waving the white flag in fighting against the assertion that certain
institutions are "too big to fail."

Even where standards are not uniform, a lack of sufficient tailoring can reshape the

banking industry, simply through the cliff effects created around particular regulatory thresholds.

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For example, capital reform and climate regulation would establish $100 billion as the key
regulatory threshold, lending additional gravity to the decision to cross, or even approach it, with
the consequence of reducing the number of institutions around that threshold. Institutions above
the threshold will face strong incentives to grow larger to achieve economies of scale.
Institutions be/ow the threshold will face strong incentives to manage their size to avoid the
significant intensification of requirements that apply as they approach $100 billion in assets.
This scenario also has significant implications for the too-big-to-fail issue, as well as for industry
competition over the long term.

Regulatory costs that are disproportionate to a firm's risk create incentives for activities
to migrate out of the banking system entirely, which we have seen as a consequence of past
regulatory reform efforts. In my view, implicit in the statutory mandate to promote safety and
soundness, and financial stability, is that we allow banks to continue serving their role in the U.S.
financial system and in support of the economy. Fidelity to the law does not require regulators to
create a bank regulatory framework that eliminates risk: banking is inherently about managing,
not eliminating, risk.

Closing
Thank you, again, for the invitation to speak with you, and I look forward to our

discussion.