Janet L Yellen: Supervision and regulation
Testimony by Ms Janet L Yellen, Chair of the Board of Governors of the Federal Reserve
System, before the Committee on Financial Services, US House of Representatives,
Washington DC, 28 September 2016.
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Chairman Hensarling, Ranking Member Waters, and other members of the committee, I
appreciate the opportunity to testify on the Federal Reserve's regulation and supervision of
financial institutions.
One of the Federal Reserve's fundamental goals is to make sure that our regulatory and
supervisory program is tailored to the risk that different financial institutions pose to the
system as a whole. As we saw in 2007-08, the failure of systemically important financial
institutions can destabilize the financial system and undermine the real economy. The
largest, most complicated firms must therefore be subject to prudential standards that are
more stringent than the standards that apply to other firms. Small and medium-sized banking
organizations - whose failure would generally pose much less risk to the system - should be
subject to standards that are materially less stringent.
The Federal Reserve has made substantial progress in building a regulatory and supervisory
program that is consistent with these principles. We have implemented key standards
designed to limit the financial stability risks posed by the largest, most complex banking
firms. We continue to work on some remaining standards and to assess the adequacy of this
package of measures. With respect to small and medium-sized banks, we must build on the
steps we have already taken to ensure that they do not face undue regulatory burdens.
Looking forward, we must continue to monitor for the emergence of new risks, since another
key lesson from the crisis is that financial stability threats change over time.
Strengthening the regulation and supervision of the largest financial institutions
The Federal Reserve's post-crisis efforts to strengthen its regulation and supervision of large
banks have focused on promoting the safety and soundness of these firms and on limiting
the adverse effects that their distress or failure could have on the financial system and the
broader economy. This orientation is consistent with section 165 of the Dodd-Frank Wall
Street Reform and Consumer Protection Act (Dodd-Frank Act), which directs the Board to
impose enhanced prudential standards on large banking organizations "in order to prevent or
mitigate risks to financial stability." Our efforts to mitigate financial stability risks posed by
large financial institutions generally fall into one of two categories. First, we aim to make
large financial institutions more resilient in order to reduce the likelihood of their failure or
distress. And second, we aim to make large financial institutions more resolvable to limit the
damage that their failure would have on the rest of the financial system and on the broader
economy.
Resiliency
To increase the resiliency of the largest banking organizations, the Federal Reserve has
established a broad set of enhanced prudential standards for large domestic and foreign
banking organizations. Together with the Federal Deposit Insurance Corporation (FDIC) and
the Office of the Comptroller of the Currency, we have implemented capital rules that require
large banking organizations to hold substantially larger amounts of high-quality capital than
they were required to hold before the 2007-08 crisis, and we have adopted a liquidity
coverage ratio (LCR) that requires these organizations to hold a buffer of high-quality, liquid
assets sufficient to meet liquidity outflows during a 30-day period of severe funding stress.
We have also proposed single-counterparty credit limits that are designed to guard against
the build-up of excessive concentrations of credit risk and, along with the other federal
banking agencies, proposed a Net Stable Funding Ratio that would require banks to maintain
a minimum level of stable funding relative to the liquidity of their assets over a one-year
horizon.
In addition to strengthening the regulation of the largest, most complex financial institutions,
we have also transformed our supervision of firms that pose elevated risk to U.S. financial
stability through the creation of the Large Institution Supervision Coordinating Committee
(LISCC).1 The LISCC is distinguished by several characteristics. First, the LISCC has
implemented a centralized, multidisciplinary approach to supervision by bringing together
experts from around the Federal Reserve System in the areas of supervision, research, legal
counsel, financial markets, and payments systems. Second, major areas of focus for the
supervision of firms in the LISCC portfolio are capital and liquidity resiliency under normal
and potentially adverse conditions in the future, as well as recovery and resolution
preparedness. And third, the LISCC complements traditional, firm-specific supervisory work
with annual "horizontal" programs that examine these firms at the same time and on the
same set of issues in order to promote better monitoring of trends and consistency of
assessments across all of the LISCC firms.
With regard to capital adequacy, the introduction of capital stress testing for large banking
organizations has been one of our signature innovations since the financial crisis. As events
during the financial crisis demonstrated, capital buffers that seem adequate in a benign
environment may turn out to be far less than adequate during periods of stress. For this
reason, consistent with the stress-testing mandate in the Dodd-Frank Act, the Federal
Reserve conducts supervisory stress tests each year on banking organizations with $50
billion or more in total assets to determine whether they have sufficient capital to continue
operations through periods of economic stress and market turbulence, and whether their
capital planning frameworks are adequate to their risk profiles. The expectation embodied in
our stress testing program that large banking organizations should maintain sufficient capital
buffers to withstand a period of significant stress promotes the resilience of those firms and
of the financial system more generally.
While our stress testing program has been successful since it was first introduced in 2009,
the crisis reinforced the need for regulators and supervisors to continually revisit the
effectiveness of their tools and adjust as needed over time. We therefore launched a review
of the Comprehensive Capital Analysis and Review (CCAR) program last year with the aim
of re-assessing our stress testing practices on a comprehensive basis. As part of this
process, we met with a wide range of stakeholders, including academics, analysts, bankers,
public interest groups, and others. We are now considering making several changes to our
stress testing methodology and process.
The leading idea that has emerged from our comprehensive CCAR review is to integrate
CCAR with our regulatory capital framework. More specifically, the regulatory capital rules
now include a firm-specific, risk-based capital surcharge for each global systemically
important bank (GSIB) and a uniform capital conservation buffer requirement above the
regulatory capital minimum for all firms. Under the approach we are considering, the existing
capital conservation buffer would be replaced with a risk-sensitive, firm-specific buffer that is
sized based on stress test results. Each firm's buffer requirement would be set equal to the
decline in its common equity tier 1 capital ratio in the supervisory stress test. The buffer
requirement would be floored at 2.5 percent of risk-weighted assets, the current level of the
capital conservation buffer, to avoid any reduction in the stringency of the regulatory capital
rules. We call this idea the "stress capital buffer," and it would effectively move the stress test
to the center of our regulatory capital framework.
For the eight U.S. GSIBs, the move to the stress loss buffer - which would be similar in effect
to including the GSIB capital surcharge in the CCAR post-stress minimum - would result in a
significant aggregate increase in capital requirements. Thus, in addition to simplifying the
capital framework by integrating CCAR with our regulatory capital rules, the stress loss buffer
would advance our macroprudential goal of making GSIBs more resilient. In contrast, the
move to the stress loss buffer approach generally would not entail a toughening of our
requirements for the 25 large banking firms that are subject to CCAR but are not GSIBs. Nor
would the move have any impact on community banks or other firms with less than $50
billion in assets.
We are also considering making certain changes to the stress test assumptions used in
CCAR. For example, under the current CCAR program, a firm's capital adequacy is
assessed by assuming that the firm continues to make its baseline capital distributions over
the stress test's two-year planning horizon. We are considering changing this conservative
assumption, in significant part because of the advent of the capital conservation buffer in the
regulatory capital rules, which limits the ability of a firm to make capital distributions when its
capital ratios are lower than the buffer requirement. Instead, we are proposing that firms
simply add one year of planned dividends to their stress capital buffer requirement in
recognition of the fact that firms generally are more reluctant to reduce dividends than share
buybacks. On this and other changes to CCAR that we are considering, we will of course
seek public input before moving to adopt them.
Resolvability
During the crisis, fears about the systemic consequences that would result from the
bankruptcies of systemically important firms motivated extraordinary government actions.
The fears proved well-founded: The bankruptcy of Lehman Brothers significantly
exacerbated the crisis. To reduce the potential that resolution of a large financial firm in
bankruptcy will be disorderly, section 165(d) of the Dodd-Frank Act requires large banking
organizations to produce living wills that help these firms prepare to be resolved in an orderly
way under the Bankruptcy Code. Although the Bankruptcy Code provides the default legal
framework for resolving a failed bank holding company, the Dodd-Frank Act also creates a
backup resolution authority that can be used if the resolution of a failed financial company
under the Bankruptcy Code would have serious adverse effects on U.S. financial stability.
The orderly liquidation authority in Title II of the Dodd-Frank Act has several features that
could reduce the systemic impact of a firm's resolution, including an orderly liquidation fund
and provisions to prevent the chaotic unwinding of a firm's derivatives, securities financing
transactions, and other qualified financial contracts. In the unlikely event that the orderly
liquidation fund does incur losses, these losses would be covered by assessments on major
financial firms and would not be passed on to taxpayers.
The Federal Reserve has recently proposed important new rules to increase the prospects
for the orderly resolution of a GSIB. Last October, the Board proposed to require the eight
U.S. GSIBs to meet total loss-absorbing capacity (TLAC) and long-term debt requirements.
The proposal would require these systemically important firms to maintain outstanding a
large quantity of long-term debt that could be used to absorb losses and recapitalize the firm
in resolution. Because, by definition, the actual equity of a bank will have been substantially
depleted - if not totally eliminated - by the time it fails, a separate long-term debt
requirement is essential to ensure that the resolution authority has the raw material from
which to manufacture new equity in resolution to recapitalize and stabilize the failed firm. For
this reason, the proposed long-term debt requirement would more assuredly enhance the
prospects for successful resolution - and thereby contribute to solving the too-big-to-fail
problem - than would a TLAC requirement on its own. The proposal would also restrict the
operations of GSIB holding companies, so that those legal entities could go through
resolution without setting off short-term wholesale funding runs or otherwise jeopardizing
financial stability.
In May this year, the Board issued another proposal to make GSIBs more resolvable. This
second proposed rule would impose restrictions on GSIBs' qualified financial contracts -
including derivatives and repurchase agreements (repos) - to guard against the rapid, mass
unwinding of those contracts during the resolution of a GSIB. The proposed restrictions are a
key step toward GSIB resolvability because rapidly unwinding these contracts could
destabilize the financial system by causing asset fire sales and toppling other firms.
Acting in conjunction with the FDIC, the Board has also sought to increase GSIB resolvability
through the living wills process. In April this year, the Board and the FDIC announced the
results of their review of the eight U.S. GSIBs' 2015 resolution plans. During this review, the
agencies evaluated the plans based on the firms' capital, liquidity, governance mechanisms,
operational capabilities, legal entity rationalization, derivatives and trading activities, and
responsiveness to prior agency feedback. The agencies found that five of the GSIBs' plans
fell short of the resolvability standard set by the Dodd-Frank Act and required those firms to
fix deficiencies in their plans by October of this year or potentially face more stringent
prudential requirements. If the agencies jointly determine that a firm has failed to adequately
remedy the noted deficiencies, the agencies may jointly determine that the company or its
subsidiaries will be subject to more stringent capital, leverage, or liquidity requirements or to
restrictions on the growth, activities, or operations of the firm. The agencies also identified
less-severe shortcomings in the plans of all eight U.S. GSIBs, which are expected to be
addressed in the next round of resolution plan submissions, due in July 2017.
The resolution planning process requires firms to demonstrate that they have adequately
assessed the challenges that their structure and business activities would pose during
resolution and that they have taken action to address those issues. Firms must also confront
the resolution consequences of their day-to-day management decisions on a continual basis,
particularly those related to structure, business activities, capital and liquidity allocation, and
governance. Firms are also expected to create a meaningful set of options for selling
operations and business lines to generate resources and to allow for restructuring under
stress, including through the sale or wind-down of discrete businesses that could further
minimize the direct impact of the firm's distress or failure on the broader financial system.
The deficiencies and shortcomings issued in the most recent plan review focus on steps
necessary to ensure these objectives are met at each GSIB on an ongoing basis.
In addition to providing the firms with our feedback on their resolution plans, the agencies
took several steps in April to improve the transparency of the resolution planning exercise.
These steps included publicly releasing the firm feedback letters, a paper outlining the
resolution plan assessment framework and firm determinations, and a document detailing the
expectations of the agencies regarding the firms' 2017 resolution plan submissions. The
expectations articulated for the 2017 plan contents build on detailed guidance previously
provided to the GSIBs in 2014 and 2015.
While the five firms that received joint deficiencies are required to fix those deficiencies by
October 2016, all of the firms that received agency feedback in April are required to submit a
full resolution plan by July 1, 2017. In these plans, firms will be required to address all
identified shortcomings, follow all guidance provided by the agencies, and meet all statutory
and regulatory requirements for their resolution plans. In meeting these expectations, the
actions that firms need to take should be substantially complete by July 2017, as previously
communicated by the agencies.
Regulation and supervision of large and regional banking organizations
In supervising banking organizations with more than $50 billion in assets but outside the
LISCC program, the Board focuses on ensuring that companies are well managed,
appropriately capitalized, and prepared to withstand potential adverse developments in the
business environment. However, because the distress or failure of a non-LISCC firm is
unlikely to have the same effect on the financial system and broader economy as that of a
LISCC firm, we do not apply the full range of rules that we apply to those in the LISCC
portfolio. For example, the Board's risk-based and leverage capital surcharges, as well as
the recently proposed long-term debt and TLAC requirements, only apply to GSIBs. Similarly,
the advanced approaches capital rules, countercyclical capital buffer, supplementary
leverage ratio, and full LCR only apply to the largest and most internationally active banking
organizations. We also scale our examination procedures to reflect the lower level of
systemic risk presented by banks with more than $50 billion in assets that are not LISCC
companies.
As a result of the comprehensive CCAR review I described earlier, we are also considering
exempting from the qualitative portions of CCAR any bank that has less than $250 billion in
total assets and that does not have significant international or nonbank activity. While we
strongly believe the CCAR qualitative review produces significant safety and soundness
benefits for the largest firms, we can achieve our supervisory goals at most medium-sized
banking firms using our normal supervisory program combined with targeted horizontal
assessments of particular aspects of capital planning, as many of these firms are now
meeting or close to meeting our supervisory expectations for capital planning processes. As
required by statute, these firms would still be subject to the quantitative portion of our stress
testing program. But even with respect to the quantitative portions of CCAR, we are
considering reducing the amount of data that these firms are required to submit for stress
testing purposes.
Regulatory and supervisory requirements are further tailored for regional banking
organizations, defined as those with total assets between $10 billion and $50 billion. For
example, while regional banking organizations must comply with capital rules, they are not
subject to a supervisory stress test or CCAR. Rather, as required by the Dodd-Frank Act,
regional banking organizations perform their own stress tests. Similarly, these companies are
not subject to enhanced prudential standards established under section 165 of the
DoddFrank Act, the LCR, or other related requirements. Instead, we conduct regular inspections of
regional banking organizations and evaluate their safety and soundness based on each
company's individual circumstances, in addition to horizontal exams we conduct of regional
banking organizations. Because many regional banking organizations concentrate their
assets and activities in banking subsidiaries that are supervised by other federal banking
agencies, we coordinate supervisory activities closely with the other U.S. banking agencies
and rely significantly on the results of their examinations, focusing our own inspections on
the parent company and its ability to serve as a source of strength to the subsidiary banks.
Community bank supervision
I know that community banks play a vital role in many of your districts. Let me say that the
experiences and challenges of community banking are not new to me. Before I became
Chair of the Board of Governors and Vice Chair before that, I spent six years as president of
the Federal Reserve Bank of San Francisco. In that role, I was involved in the supervision of
a substantial number of community banking organizations in the nine states of the San
Francisco District. Among the lessons that experience reinforced is that when it comes to
bank regulation and supervision, one size does not fit all. To effectively promote safety and
soundness and to ensure that institutions comply with applicable consumer protection laws
without creating undue regulatory burden, rules and supervisory approaches should be
tailored to different types of institutions such as community banks.
The Federal Reserve supervises more than 800 community banks and more than 4,000
holding companies that control small depository institutions. These are banking organizations
with total assets of $10 billion or less. In supervising community banks, we follow a
riskfocused approach that aims to target examination resources to higher-risk areas of each
bank's operations and to ensure that banks maintain risk-management capabilities
appropriate to their size and complexity. In the wake of the crisis, we have taken steps to
refine this process by using the financial data we collect from banks to calibrate our
examination procedures based on risk. We believe this will help us to identify and address
emerging risks and to ensure that community bank examiners with specialized expertise are
allocated to the institutions exhibiting the highest risks. We also implemented a risk-focused
consumer compliance examination framework for community banks in 2014 that is intended
to allow examiners to spend less time on low-risk compliance issues so that issues more
likely to result in harm to consumers get more attention.
The Federal Reserve and the other banking agencies are currently in the process of
completing the Economic Growth and Regulatory Paperwork Reduction Act (EGRPRA)
review. Under EGRPRA, the federal banking agencies are required to conduct a joint review
of their regulations every 10 years to identify provisions that are outdated, unnecessary, or
unduly burdensome. The Federal Reserve views this review as a timely opportunity to step
back and identify ways to reduce regulatory burden, particularly for smaller or less complex
banks that pose less risk to the U.S. financial system. In carrying out this review, the
agencies sought public comment on their regulations and held several roundtable
discussions with bankers and interested parties to gather additional feedback on sources of
burden. Themes emerging from these comments include streamlining the Call Report,
reducing examination frequency, raising long-standing dollar-based thresholds for appraisals,
and reducing the complexity of capital requirements for smaller banks. In response to public
comments on examination frequency, the agencies have already approved interim rules to
implement a provision of the Fixing America's Surface Transportation Act (FAST Act), which
raises the asset threshold for insured depository institutions that are eligible for an 18-month
examination cycle from $500 million to $1 billion. As a result of raising the threshold, eligible
institutions will be subject to fewer safety and soundness and Bank Secrecy Act exams. The
agencies are also exploring potential options for alleviating some burdens of appraisal
requirements and are actively considering proposals to simplify regulatory capital
requirements for community banks.
In addition, the banking agencies, under the auspices of the Federal Financial Institutions
Examination Council, recently issued a proposal for a new and streamlined Call Report for
community banks. The proposal would eliminate certain data items and reduce the reporting
frequency of many other data items. As a result, banks with less than $1 billion in total assets
would submit a Call Report with about 40 percent fewer data items than the existing Call
Report. The proposal incorporates comments the banking agencies received from
community banks during several outreach events used to gather information on the
challenges faced by community banks in preparing Call Reports.
Congress may also wish to consider carving out community banks from two sets of
DoddFrank Act requirements: the Volcker rule and the incentive compensation limits in section
956. The risks addressed by these statutory provisions are far more significant at larger
institutions than they are at community banks. In the event that a community bank engages
in practices in either of these areas that raise heightened concerns, we would be able to
address these concerns as part of the normal safety-and-soundness supervisory process.
While the banking agencies have tailored the Volcker rule and have proposed significant
tailoring of incentive compensation rules, community banks and supervisors would benefit
from not having to focus on regulatory compliance for matters that are unlikely to pose
problems at smaller banks.
Current conditions
Having reviewed some of the major elements of our regulatory and supervisory programs, let
me offer a few brief remarks about the current state of the firms we regulate.
In response to regulatory and supervisory pressures, the financial condition of the U.S.
GSIBs has strengthened considerably since the crisis. Common equity capital at the eight
U.S. GSIBs alone has more than doubled since 2008, representing an increase to almost
$800 billion. Moreover, these firms generally have developed much more stable funding
positions. The largest banking organizations have increased their holdings of high-quality
liquid assets by over $1 trillion over the past five years, at the same time as they have
substantially reduced their reliance on run-prone sources of funding. Reducing run-risk is a
central goal of post-crisis regulation and supervision.
Our examinations have found large and regional banks to be well capitalized. Both large and
regional banking organizations have shown improved profitability since the depths of the
financial crisis, although these banks have also faced challenges in recent years because of
weak growth in interest and noninterest income. Both large and regional institutions have
seen robust growth in commercial and industrial lending, which supports sustainable job
creation.
Finally, community banks are significantly healthier. More than 95 percent are now profitable,
and capital lost during the crisis has been largely replenished. Loan growth is picking up, and
problem loans are now at levels last seen early in the financial crisis.
Conclusion
In conclusion, our post-crisis approach to regulation and supervision is both forward-looking
and tailored to the level of risk that firms pose to financial stability and the broader economy.
Standards for the largest, most complex banking organizations are now significantly more
stringent than standards for small and medium-sized banks, which is appropriate given the
impact that the failure or distress of those firms could have on the economy. As I have
discussed, we anticipate taking additional actions in the near term to further tailor our
regulatory and supervisory framework.
Yet even as we finalize the major elements of post-crisis reform, our work is not complete.
We must carefully monitor the impact of the regulatory changes we have made and remain
vigilant regarding the potential emergence of new risks to financial stability. We must stand
ready to adjust our regulatory approach where changes are warranted. The work we do to
ensure the financial system remains strong and stable is designed to protect and support the
real economy that sustains the businesses and jobs on which American households rely.