For release on delivery
12:40 p.m. EST
December 11, 2020
The Eye of Providence: Thoughts on the Evolution of Bank Supervision
Remarks by
Randal K. Quarles
Vice Chair for Supervision
Board of Governors of the Federal Reserve System
at
Federal Reserve Board, Harvard Law School, and Wharton School Conference: Bank
Supervision: Past, Present, and Future
(via webcast)
December 11, 2020
Torrential thanks to our partners Harvard Law School and The Wharton School for
organizing this conference, and to the Federal Reserve staff who have played a key role. And an
equally huge thanks to all of the moderators and panelists who are participating in today's event
and to all of you who are tuning in. I have very much enjoyed the discussion so far, and I hope
that the conference will encourage both more and a wider variety of academic work on bank
supervision.
In many respects, the focus of today's conference on bank supervision, rather than
regulation, and the relatively recent efflorescence of scholarly attention to that topic, are
welcome new developments. In other respects, however, the question of the proper scope of
bank supervision is not a new topic at all. In going through some family papers recently, I came
across this cri de coeur from one Elton Hall, president of a small bank in Victor, Idaho, as
quoted in the Teton Valley News in November, 1921:
The government has so governed [my] bank that [I] no longer knew who owned it. I
am inspected, examined and re-examined, informed, required, restrained, and
commanded. . . . I am supposed to be an inexhaustible supply of money . . . , and
because I will not sell all I have and go out and beg, borrow, or steal money to give
away, I have been cussed, discussed, boycotted, talked to, talked about, lied to, lied
about, held up, hung up, robbed and nearly drained, and the only reason I am clinging
to life is to see what in hell is coming off next.
Were Mr. Hall transported to the District of Columbia in 2020, he would immediately
realize that he had clearly had no idea what was "coming off next" if he had thought he was
over-imposed upon in Idaho's Teton Valley in the winter of 1921. But before the bankers in the
congregation become too inclined to commiserate with him, I should note that the reason I know
anything about Mr. Hall, and the reason his quote is among those family papers, is because his
bank failed not so many years thereafter, as did nearly half the small banks in the country
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between 1920 and 1930. Mr. Hall's bank on the western slope of the Tetons was acquired by a
visionary young banker from Utah by the name of Marriner Eccles. This was during the Roaring
'20s, well before the Great Depression and the Banking Crisis of 1933. Before the evolution of
modern supervisory practices, bank failures were extremely common, even in boom times.
So, how should we think about this new, yet very old, question? I'd like to begin as
many of you have today, by focusing first on regulation-as a way of throwing into relief some
key issues that are both important and hard about its cousin supervision.
One of my goals at the Board of Governors has been to make our regulatory framework
simpler, more consistent, more predictable, and more efficient. This approach is not new. It
draws on many decades of practical experience and public policy analysis. At its most basic, this
approach rests on the premise that we should continuously challenge ourselves to make sure that
our policies are achieving their intended objectives, based on evidence and a data-driven
assessment of their impact on the public.
These principles-simplicity, consistency, and predictability-are all connected to what
is perhaps a more fundamental principle of regulation, and indeed of law itself-transparency.
Transparency makes the intent of regulators clear and their actions more predictable to those
regulated. Regulations are more effective when they are well understood and more effective
when their predictability and consistency build respect for the fairness of regulation that
encourages compliance. Transparency helps guard against regulation that is arbitrary or
capricious. Transparency is enshrined in statutory process protections such as those in the
Administrative Procedure Act, which facilitates understanding and communication.
All these principles-simplicity, predictability, transparency, efficiency-lead to better
regulatory outcomes. All other things equal, simpler rules are better because they are easier to
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understand, to implement by banks, and to supervise by examiners. Predictable, consistent, and
clear rules are more effective because they are consistent across firms and over time. In addition,
we develop rules through an iterative process that takes place in the open. Through this process
we learn about potentially unanticipated consequences-which allows us to avoid these
surprises, which are in no one's interest. The public comment process also naturally facilitates a
dialogue with the organizations that would be subject to the rules, as well as any interested party,
helping the government to produce a regulatory framework that takes into account both benefits
and costs. A focus on efficiency helps ensure that we avoid any unnecessary burden and
externalities.
We relied on these principles in establishing the new regulatory framework in the wake
of the global financial crisis. The essential elements of that framework-which now includes
dynamic and risk-sensitive capital requirements and rules-based, quantitative liquidity
standards-all reflect extensive and significant consultations with the public and careful analysis
of the impact that these rules will have on individual banks and the U.S. banking system. Our
benchmark for capital adequacy is now based on standardized measures of risk and leverage
across all banks. This is supplemented by an annual stress test with extensive transparency and
disclosure around the process and results that provides additional, consistent risk sensitivity. We
now regulate liquidity as one of our enhanced prudential standards for large banks, with two
clear quantitative standards-the short-term liquidity coverage ratio (LCR) and long-term net
stable funding ratio (NSFR) requirements-and clear expectations for liquidity risk management,
articulated in a regulation that went through a public notice and comment process.
Partly as a product of these improvements, we have made our regulations more efficient
by better differentiating among risks. Our capital rules require firms that hold riskier positions
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either to maintain capital that addresses those risks or to take steps to de-risk. Our liquidity rules
similarly require firms with more unstable funding to hold more liquid assets or to improve the
stability of their funding. In addition, last year the Board adopted changes to our overall
regulatory capital and liquidity frameworks that differentiates among the systemic risks
presented by individual banks. Under the revised framework, the most complex, systemically
important firms are subject to the most stringent requirements, and less-complex firms are
subject to less-stringent requirements. In the long run, these changes will lead to fairer, more
efficient results, while preserving the safety and soundness of the U.S. banking system and
broader financial stability.
Because of the improved regulatory framework in place early this year, banks were in a
strong position to deal with the challenges of the COVID event. For example, in March of this
year, customers of U.S. banks drew down nearly $480 billion on existing lines of credit to cover
cash needs during the severe disruption in revenues in the early days of the COVID event-by
far the largest monthly increase in history. Banks were able to fund these loans without notable
problems in part by drawing on liquidity buffers created by the new regulatory system. They
have not only maintained, but actually increased their capital during this time-notwithstanding
the large provisions taken earlier in the year. And they have continued to extend credit
throughout the protracted evolution of the COVID event, to this point largely satisfying the
demand for credit in the economy.
Of course, having clear, consistent, predictable, and efficient rules of the game is not the
end of the story. Our rules are not an academic exercise. They represent concrete, binding
requirements on real people and real businesses. Our obligations to the public mean we need to
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verify that our rules are being followed, detect emerging risks, and make sure any deficiencies
are swiftly addressed. This is the task of the bank supervisor, rather than the bank regulator.
Regulation and supervision are different tasks, and I have spent this time reviewing how
we have pursued the goals of simplicity, predictability, transparency, and efficiency in regulation
in part to lay the groundwork for showing how much harder it is to pursue those goals in the
realm of supervision. Regulation and supervision both flow from the statutory authority granted
to the Federal Reserve and the other banking agencies by Congress establishing our duty to
promote a safe and sound banking system. Regulation does that on a generalized, system-wide
basis. Supervision, in contrast to regulation, looks at firm-specific issues, such as how a firm's
idiosyncratic risks are evaluated under our regulations, and at risk-management frameworks that
cannot easily be assessed through standardized risk measures. For example, while our capital
rules require banks to hold a specific level of capital, our exams focus on subjects such as the
plans of management to make sure they can meet those capital requirements on an ongoing basis.
Supervisors summarize the results of these examinations and their overall assessment of a firm in
the form of a supervisory rating, the importance of which I will discuss shortly.
The progress we have made on regulation creates an opportunity for us to focus more of
our attention on supervision and the principles of simpler, more consistent, more predictable, and
more efficient supervisory standards. For example, because the Board found that there had been
significant improvements in risk management since the global financial crisis, we removed the
"qualitative objection" from our stress testing process.1 Similarly, we simplified our capital
1
During CCAR, supervisors make a "qualitative assessment" of a firm's capital planning process. Formerly, firms
with a deficient capital planning process were subject to an objection by the Federal Reserve of the firm's capital
plan, which resulted in limitations on the firm's capital distributions. The Board removed this requirement in 2019
because of the progress firms had made in improving their capital planning practices. See 84 Fed. Reg. 8953
(March 13, 2019).
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framework through the introduction of a stress capital buffer (SCB) requirement.2 How should
supervision evolve in light of the new stronger and more comprehensive regulatory edifice we
now have in place?
An example: after we emerge from the COVID event, we will no longer need to
maintain temporary limitations on capital distributions by large banks and can instead rely on the
regulatory capital framework that the Board established earlier this year-the SCB. Among its
many advantages, under this framework we will no longer need to review periodic requests from
banks for additional capital distributions. Instead, the SCB sets a clear and explicit capital target
that firms must stay above at all times. As a result, firms can rely on that SCB target to define
how much capital they can distribute in any given calendar quarter. This is a better process
because it is more predictable and more efficient.
That said, we may still want to conduct a limited review of the capital plans of banks to
give some insight into risks that the stress test might not fully pick up. For example, if a firm
enters a new line of business and does not yet have a good framework for assuring its managers
can measure the results of that business in light of its risks, supervision can detect that
shortcoming and the firm can help address this vulnerability before the uncaptured risks
materialize. Similarly, our new long-term stable funding rule-the NSFR rule-provides
objective standards to address risks that fall outside the boundaries of our short-term funding
requirement-the LCR rule-and thereby takes some pressure off supervisors to monitor these
risks on a case-by-case basis. However, the LCR and NSFR do not address all sources of
liquidity risk, and poor dynamic liquidity risk management can lead to a firm's failure just as
2
The SCB uses the results of the annual stress tests to determine how much capital firms are required to hold. As a
result, the SCB combined two separate capital frameworks into one and simplified the overall capital regime for
large banks.
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surely as a present-tense lack of liquidity. In these ways, bank supervision can act as an early
warning system and identify risks before they metastasize into problems that drain a firm's
financial resources or liquidity position.
Yet as important as the practice of supervision is, these examples also show that it is
inherently more judgmental, nuanced, discretionary, variable, and opaque than the practice of
regulation. And variability and opacity breed distrust, even when that distrust is not at all
merited. The point here is that all the benefits that come from simplicity, predictability, and
transparency would be equally valuable in supervision-but necessarily much harder to obtain
while maintaining the benefits of supervision, which are substantial if we are not to return to a
world where half the small banks in the country will fail during one of the most prosperous
decades in our history.
Keeping all this in mind, and given the success of our refinement of the overall regulatory
framework, I believe it is natural to reflect on our overall supervisory communications, including
our supervisory ratings framework, to consider ways to simplify it and make it more efficient,
and especially make our ratings more consistent and more predictable. We already have a good
deal of transparency around our supervisory standards-we publish our supervisory manuals, we
publish guidance, and we seek public comment on the most significant guidance. We also
recently published standards for how we would assign firms to the large institution supervision
coordinating committee, or LISCC, portfolio.3 However, in contrast to the rulemaking process,
and in order to appropriately protect a bank's confidential business information, the vast majority
of the communication about the bank supervision process takes place confidentially. The most
3
The LISCC, established by the Federal Reserve in 2010, is the supervisory program for those large financial
institutions that pose the greatest risk to U.S. financial stability. For more information, see
https://www.federalreserve.gov/supervisionreg/large-institution-supervision.htm.
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notable exceptions are when we find material deficiencies at a bank and take a public
enforcement action to correct them.
Supervisory ratings are an interesting and special case because they are confidential
communications that can have public consequences. A supervisory rating is a confidential
assessment of the strength of a bank in one or more risk areas, or, in some cases, a composite
view of the aggregate risks facing the bank. Ratings have the obvious benefit of summarizing
the overall condition of a firm. Among other considerations, this summary includes qualitative
judgments about risk management and an assessment of whether the firm is in compliance with
applicable regulations, such as capital and liquidity requirements. Ratings also promote
comparative analysis across firms that face similar risks.
Ratings date back to the first half of the 20th century, and possibly earlier, when they
were used to classify banks, in much the same way as examiners assign ratings today.4 The
modern version of ratings was the result of the establishment by Congress of the Federal
Financial Institutions Examination Council (FFIEC) in 1978. The FFIEC established the
"CAMEL" rating system in the same year to promote consistent examination practices across
depository institutions. The Federal Reserve followed suit with a supervisory rating system for
bank holding companies in 1979. Since that time, ratings have become enshrined in the federal
banking laws. In particular, they play a role in interstate branching requirements and in
determining whether or not holding companies can engage in expanded financial activities.
4
See George R. Juncker, "A New Supervisory System for Rating Banks," FRBNY Quarterly Review, Summer 1978,
https://www.newyorkfed.org/medialibrary/media/research/quarterly_review/1978v3/v3n2article8.pdf; Statement of
Brenton C. Leavitt, Board of Governors of the Federal Reserve System, before the Commerce, Consumer, and
Monetary Affairs Subcommittee of the House Committee on Government Operations, Federal Reserve Bulletin 62
(February 1976), https://fraser.stlouisfed.org/title/federal-reserve-bulletin-62/february-1976-21494/fulltext; see also
James Bergin and Kevin Stiroh, Why Do Supervisors Rate Banking Organizations? (unpublished manuscript).
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While the ratings themselves remain confidential supervisory information, the Federal
Reserve has taken steps to provide information to the public around the rating process. For
example, the standards we use to assign the ratings have always been published. In addition, the
Board has sought public comment on the two most recent iterations of its ratings systems for
holding companies, the RFI rating system and the LFI rating system.5 And in the past year, the
Board began publishing aggregate data on supervisory ratings-organized by different bank
cohorts-as part of its report on bank supervision.6
One concept that is inextricably linked to a supervisory rating is whether or not a firm is
"well managed." By law, in order to be well managed a firm must have at least a satisfactory
management rating, if any is given by its supervisor, and a firm also must have at least a
satisfactory overall or composite rating. When the Gramm-Leach-Bliley Act expanded the range
of financial activities that were permissible for companies that own banks, such as securities
underwriting and insurance underwriting, it did so with certain conditions. To elect to be a
"financial holding company" and be eligible to engage in these types of expanded financial
activities, a bank holding company and its lead depository institution subsidiary, among other
things, must be and remain well-managed.7
Because of these significant consequences, I believe it is appropriate to take note of the
process distinctions between the development of rules and the development of supervisory
ratings. Rules are drafted in full view of the public, subject to a comment period before they
5
"RFI" (Risk Management (R); Financial Condition (F); and Impact (I)) is the Federal Reserve's rating system for
all bank holding companies except for those subject to the LFI (Large Financial Institution) rating system.
6
Board of Governors of the Federal Reserve System, Supervision and Regulation Report: November 2020
(Washington: Board of Governors, November 2020),
https://www.federalreserve.gov/publications/files/202011supervision-and-regulation-report.pdf.
7
In addition, the company must be "well capitalized" under the Federal Reserve's regulations and have at least a
satisfactory rating for compliance with the Community Reinvestment Act. To be well capitalized, the company
must meet quantitative capital requirements that exceed the minimums.
become final, and federal agencies have an obligation to provide a rationale for their rules. In
contrast, supervisory ratings are confidential and have immediate effect. Banks are not permitted
to disclose them. Although, as I have discussed, there are published standards as to how bank
supervisors should assign these ratings, there will always be borderline cases and close calls, and
these decisions are made out of the view of the public.
There are at least two reasons why it is critical that we get ratings correct. The first is
that the supervisory rating is the most important communication that we have with firms. It
encapsulates our expert judgment of the firm and lets the firm know how its performance
compares with our standards. And second, as discussed, ratings have material real-world
consequences. A firm with unsatisfactory ratings faces significant competitive disadvantages
relative to firms deemed to be satisfactory. As noted, these firms are prohibited from expanding
their range of financial activities and will generally face headwinds in acquisitions.
Since the financial crisis, our supervisors have identified potential weaknesses at firms
and encouraging them to address those weaknesses. And firms now have substantially stronger
and more resilient risk-management systems. They are better able to identify, measure, and
manage their risks. These improvements have not gone unnoticed. As our supervision report
demonstrates, the overall ratings trajectory in the industry has been quite positive.8
There are some straightforward steps we could take to simplify our ratings, with no loss
of effectiveness. We already have a model for a simpler ratings framework. The new
framework that applies to our largest firms, the LFI ratings framework, focuses on the three areas
8
Supervision and Regulation Report,
https://www.federalreserve.gov/publications/files/202011-supervision-andregulation-report.pdf.
that are the core of our supervisory focus: capital, liquidity, and governance.9 We could consider
a similar simplification to the RFI rating system that applies to less-systemic holding companies
and the CAMELS ratings system that applies to depository institutions. In terms of improving
regulatory efficiency through ratings, being clearer to firms about how we apply these standards
would help to promote a more efficient banking system. In particular, we could be clearer about
how we weight the various factors that generate the rating. Banks could benefit because they
would be better positioned to anticipate supervisory feedback and understand what steps they
need to take to improve their ratings. Supervisors can benefit by being grounded in more
predictable criteria.
My concern is that, despite the fact that our examiners have used ratings for almost
100 years, we don't have a particularly well-developed theory of ratings-principles regarding
the internal processes and standards that promote consistency and predictability in our
assessment of the condition of banks. As I've discussed, there is broad agreement that ratings
are a beneficial, even necessary, part of bank supervision. Yet we have very few studies or other
empirical support for this conclusion. This stands in sharp contrast to the analysis behind the
long list of regulatory achievements that I mentioned. To give an example, we have a pretty
good idea, grounded in economic analysis, about how much capital a global systemically
important bank, or G-SIB, needs to maintain to promote its safety and soundness but not nearly
as much support for our view about where to draw the line between a satisfactory rating and an
unsatisfactory rating. For example, at a large global financial firm, what should be the difference
between a satisfactory and unsatisfactory rating on capital planning, provided the firm otherwise
9
As a formal matter, the three ratings components are capital planning and positions, liquidity risk management and
positions, and governance and controls.
has strong capital levels? Where should we draw that line? How do we decide the close calls,
and what is our default for ties?
I don't know what the right answer is, and I suspect that it will vary depending on the
circumstances. Although there will be a range of qualitative factors that affect our conclusion, it
must be the case that we can learn from our previous experiences and distill a presumptive
answer. That sort of approach, one grounded in analysis and based on evidence, has ably
supported our regulatory framework. I would like to see what science can bring to ratings. I
think this could be especially helpful in terms of the consistency and predictability of ratings.
Since ratings are assigned by humans and humans are fallible, being more deliberate about the
processes behind them can only help us. While we have made some progress in making ratings
simpler and therefore more efficient, and more consistent with actual supervisory practices, I
would like to see our approach to ratings made more express and deliberate. Since the global
financial crisis, the Fed, along with the other prudential supervisors, has implemented a number
of controls to improve consistency and support appropriate calibration of ratings, as we view
them internally. We have tools in place to monitor ratings and detect whether there is any
unusual variability in them. I suspect there is more work that could be done to use evidence and
make sure our processes facilitate consistent results.
As I have alluded to, most of these efforts have been inward-facing, and we could benefit
from efforts to show the public that our ratings are consistent and predictable. I see two paths to
achieve this goal. One of those is oriented toward processes and procedures. One is more
substantive. They are not mutually exclusive.
In terms of processes and procedures, there is always the question of whether ratings are
consistent when administered in different circumstances by different people. I would like to
explore approaches to ratings that would yield similar results when those ratings are assigned by
different staff and across different points in time. One way to do this would be to subject ratings
to the scrutiny of multiple parties with a range of perspectives and experiences. This is how the
public rating agencies, such as Moody's, Fitch, and S&P, approach ratings, through ratings
committees. And this is how we approach rating the largest, most systemically important firms
through the LISCC, where a committee that includes independent Federal Reserve experts has an
opportunity to provide feedback on the ratings of the firms in the LISCC portfolio. Designing
this process so that it is reliably consistent and predictable for all banks is an area we should
study further. Another method we could explore is to dedicate some portion of our exam work to
reviewing compliance with concrete regulatory standards, such as some of our liquidity risk-
management standards, where the standards lend themselves to that approach. And we would
commit in advance to giving the findings from these reviews a particular weight in our ratings
discussions. I think this overall model-where the supervisory assessment is vetted by a Federal
Reserve committee with independent views, or at least reviewed by staff within the Federal
Reserve outside the normal assessment process, and where we explicitly take compliance with
regulatory standards into account in assigning ratings-could be a good one for helping to
promote greater consistency and predictability, especially in cases where the subject matter lends
itself to such standards.
Another process improvement involves guidance. At times, we find it helpful to
elaborate on our regulatory standards through supervisory guidance. Some risk areas that don't
easily lend themselves to regulation, such as certain kinds of risk management, also can benefit
from supervisory guidance. In both cases, we can enhance the predictability of our supervisory
process by inviting public feedback on any applicable guidance or other supervisory standards.
For example, in connection with a recent rule on our capital planning requirements, we invited
public feedback on our outstanding supervisory guidance on capital distributions for firms of all
sizes. In the recent past, we also have sought comment on our approach to risks associated with
governance and internal controls. We will continue to look for feedback on our guidance. All of
these approaches will improve the predictability of our ratings and also improve their legitimacy.
In terms of substantive changes to show the public that ratings are consistent and
predictable, my lodestar would be to rely wherever possible on empirical analysis to direct our
policy choices and to be open to change where supported by this analysis. As supervisors, we
should be extremely supportive of efforts to better understand ratings as an assessment and
communication tool, as well as those that make our supervision processes have more repeatable
outcomes. We should encourage our examiners and economists to conduct more empirical
analysis around supervisory ratings. For example, some recent scholarship suggests ratings can
have a positive impact on reducing the insolvency risk of supervised firms.10 We should do
more analysis and careful examination to identify what drove those results.
As we conduct this analysis, my sense is that we should focus on two main variables: the
consequences of the ratings that I've described-for example, a firm having its activities or
acquisitions curtailed-and whether or not these consequences are properly calibrated relative to
the circumstances that gave rise to the rating. To illustrate, let's return to the earlier example of a
firm with a deficiency related to the risk management of its capital adequacy but that has proven
itself through our stress tests to have sufficient financial resources. In contrast, imagine a bank
that does not share the risk-management deficiency but whose stress test results indicate that the
10
Allen N. Berger, Jin Cai, Raluca A. Roman, and John Sedunov, Supervisory Enforcement Actions against Banks
and Systemic Risk, working paper, September 2020, available at SSRN,
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3696428.
firm has inadequate capital. Our assessment for both firms may be that each should receive an
unsatisfactory capital rating.
In my opinion (and I acknowledge that there are some who would reasonably disagree
with me) between the two firms, the firm that faces a potential capital shortfall should be the
graver concern. Yet, the essential message to both firms and a likely consequence of the
rating-the risk of falling out of well-managed status-is identical. To me, this outcome makes
no sense. Why should the firm that is objectively weaker face the same consequences as the firm
that is objectively stronger?
Although the law dictates the most material consequences of an unsatisfactory
management rating, we have the authority to define that rating and its calibration, as well as to
define any additional supervisory consequences that are not prescribed in the law. I believe it is
well worth our while to consider this calibration. Accordingly, I have directed Board staff to
look into the following issues:
First, the placement of the qualitative elements of our ratings frameworks. There is
somewhat more discretion in applying these elements relative to the quantitative regulatory
requirements. These elements traditionally have been spread across all the ratings components,
including capital and liquidity. Is this the best placement?
Second, ways of being clearer to the public about how we, as supervisors, weight the
qualitative and quantitative elements of our ratings. How could we best go about communicating
this weighting? Are the relative weights that we apply correct?
Third, the conclusions, if any, we can draw about the effectiveness of our new LFI ratings
framework relative to our RFI ratings framework. For example, has the lack of a composite
rating in the LFI ratings framework been beneficial from a supervisory communications
standpoint, as intended?
If our ratings are poorly calibrated, we run the risk of being less effective in our
supervision. We also could be providing aggregate ratings that are misleading. Although I
believe our examiners do rate banks accurately and dispassionately, based on our written
standards, a closer look would help identify any instances where that's not the case and what
improvements and changes might be needed.
I believe the Federal Reserve has a duty to assess our supervisory practices with the same
vigor as we have assessed our regulations. Providing ratings that are based on well-calibrated,
consistent, and predictable standards can only be to the benefit of everyone. Even if we were to
make no changes to our ratings frameworks, going through the process of assessing