Fed's 'tailoring' initiative may be easier said than done

• Key insight: The future of regulatory tailoring hinges on the Federal Reserve's ability to reach consensus on how and when to impose tighter regulatory constraints on banks as they become more systemically important. 
• Expert quote: "These are good exercises for any bank, whether or not they're required by regulation. It's good housekeeping, good hygiene. Banks recognize that, which is why many of them run their own internal stress tests." — Jarryd Anderson, partner, Ropes & Gray

The Federal Reserve's effort to reform its regulatory thresholds has one thing going for it: everyone agrees that asset size alone is a poor proxy for systemic risk. But, unfortunately for the Fed, that's where the consensus ends.

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Fed Vice Chair for Supervision Michelle Bowman wants to raise the thresholds at which banks move into higher categories of oversight. In a recent speech she said the central bank would put forth a proposal by the end of the year to all more banks to remain in the lowest level of regulatory scrutiny. 

"By expanding the range of institutions treated as community banks that operate using a traditional community bank business model and relationship banking and appropriately modifying the supervisory expectations and regulatory requirements for these firms, we will preserve safety and soundness while effectively applying appropriately tailored and risk-calibrated supervision and regulation," Bowman said in a speech earlier this month.

But just three years ago, the previous vice chair for supervision, Michael Barr, was eying reforms in the other direction, returning to a model that subjects more banks to enhanced prudential standards. 

At the time, Barr argued that a 2019 change to the tailoring framework that raised the threshold for heightened oversight from $50 billion to $100 billion contributed to the Fed's lax oversight of Silicon Valley Bank ahead of its shocking collapse. 

"Our experience following SVB's failure demonstrated that it is appropriate to have stronger standards apply to a broader set of firms," Barr wrote in a letter that accompanied the Fed's report on the failure in April 2023. "As a result, we plan to revisit the tailoring framework, including to re-evaluate a range of rules for banks with $100 billion or more in assets." 

Since 2019, the threshold for a bank to be considered a "community bank" and thus exempt from many of the more rigorous supervisory requirements has been $10 billion of assets. Banks between $10 billion and $100 billion have been categorized as regional banks — subject to more stringent rules —  and those above $100 billion have been deemed large banks and subjected to enhanced oversight, which itself is phased in across four increasingly stringent tiers, which are defined by asset size, cross-border activity and nonbank exposure. 

Barr never formally pursued a reform to the tailoring framework. He resigned from his post as the Fed's top regulator early last year to avoid a potential legal battle with the White House, which might have arisen had President Donald Trump moved to fire him. 

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Still, to advance her preferred tailoring reforms, Bowman will need to win the support of a majority of the Fed Board of Governors — a group that still includes Barr and two other Biden appointees.

In their own ways, Bowman and Barr arrived at a similar conclusion about the current regulatory framework: that $100 billion of assets is not the optimal threshold for determining systemic riskiness. That conclusion is shared by a broad array of policy analysts and advocates, who have concluded that asset size is a poor proximity for a bank' systemic footprint.

"You can have a large bank that is simple and only involved in lending, and you can have a small bank that is very complex with a lot of illiquid loans, derivatives, swaps and cross-border activities," said Mayra Rodriguez Valladares, a risk consultant and managing principal at MRV Associates. "Asset size does not tell the whole story."

Rodriguez Valladares said some banks well below the $100 billion threshold pose a systemic threat should they fail, not least because of their interconnectedness with other, similarly sized banks. She added that the fact that there are few banks that could readily purchase a struggling bank with between $50 billion and $100 billion of assets suggests some degree of enhanced oversight is warranted for banks of that size. 

Clifford Rossi, a University of Maryland business school professor and a former risk manager at Citibank, Washington Mutual and other banks, said a better approach to regulatory tiering would take into account the totality of a bank's risk profile. He highlighted organizational complexity — including how many subsidiaries, legal entities and business lines a bank has — size of off-balance sheet activity, reliance on uninsured deposits and geographic footprint as risk indicators that should be considered. 

"If, at the end of the day, we're trying to develop a regulatory framework that lessens the potential for contagion if a bank gets into trouble, then I would favor developing a standard that weighs some of these other factors rather than just assuming once a bank moves from $99.9 billion in assets to $100 billion it magically becomes systemically important," Rossi said.

Bowman has for years indicated that she would like to move the tailoring framework in a more discretionary direction. Rather than calling for the $10 billion cutoff for community banks to be raised across the board, she has said it should be extended for firms that continue to operate in a community bank fashion. 

Yet, defining a "traditional community bank business model" and evaluating whether banks are adhering to brings along its own challenges. One of the reasons blanket thresholds were implemented in the first place, and remain in place today, is their simplicity and predictability. 

Irene Oh, chief risk officer of East West Bank, which has about $86 billion of consolidated assets, said her firm has gradually been building up its compliance capabilities in preparation for reaching Category IV status once it crosses the $100 billion mark. 

Category IV banks are subject to a host of liquidity management and reporting requirements as well as the Fed stress testing regime, which brings with it dynamic minimum capital standard under the stress capital buffer. These mandates are costly and time consuming, but Oh said adopting them early brings multiple advantages.

"Improving your analysis and understanding of your liquidity, capital, stress testing and risk management practices are all practical things to do as you grow, especially if you view it not only as a regulatory exercise, but also as a way to improve the safety and soundness of the bank," Oh said. "That's how we've looked at this."

Whether or not the forthcoming reforms take business models or other bank-specific factors into account remains to be seen. What is clear is that they will seek to increase the category entry thresholds — currently $100 billion for Category IV, $250 billion for Category III and $700 billion for Category II banks. Category I banks are the global systemically important banks. 

"Among many other shortcomings, [the current] approach does not account for economic growth and inflation over time," Bowman said in a recent speech. "As a result, firms with stable growth, consistent business models, and no change in risk profile end up crossing asset thresholds and becoming subject to increasingly complex and burdensome regulatory requirements and supervisory expectations."

Total assets held by commercial banks have increased from $17.7 trillion at the beginning of 2020 to more than $26 trillion today, according to data tracked by the Federal Reserve Bank of St. Louis, an increase of nearly 50% and a compound annual growth rate of around 6% — exceeding even the elevated average annual inflation rate of around 4.5% over that same span.

Bowman suggested adjusting the thresholds to align with the nominal growth in gross domestic product since 2019. She also noted that any revisions should index the thresholds to economic growth moving forward, to save banking agencies from having to constantly revisit the issue.

The Fed is able to implement some changes to its regulatory thresholds independently. The 2018 Economic Growth, Regulatory Reform and Consumer Protection Act, granted the central bank discretion over how it tailors its regulation of banks between $100 billion and $250 billion of assets. Changing standards for larger banks would require another act of Congress — something Bowman said she would be willing to pursue. 

"Looking ahead, we will reconsider these regulatory thresholds and will work to support Congress in updating thresholds that have become outdated and too low relative to the broader economy," Bowman said in her early October speech.

Whatever changes come out of the Fed's latest push on tailoring, Jarryd Anderson, a partner at the law firm Ropes & Gray, said banks should move cautiously before scaling back any compliance efforts they have undertaken in preparation for entering the next regulatory tier. 

Anderson said banks should weigh not only the immediate cost of compliance, but also how hard it could be to get their compliance machines back up and running if the policy pendulum swings in the other direction. He also encouraged banks to embrace the independent value of practices like stress testing and resolution planning as risk-management tools, even when they are not required.

"These are good exercises for any bank, whether or not they're required by regulation. It's good housekeeping, good hygiene. Banks recognize that, which is why many of them run their own internal stress tests," he said. "And with resolution planning, even if a plan is never put into action, there's real value in having management and the board think through those scenarios in advance."

Oh said East West would appreciate having more time before entering Category IV oversight, but she noted that an increase in the entry threshold would not change the bank's approach to compliance.

"We've always been able to meet regulatory and supervisory requirements. We expect to do so for the [Large Financial Institution] requirements, whether they stay at $100 billion for Category IV or not," Oh said. "Whether the threshold is increased or not, we will be prepared. We're not waiting to do the things that we need to do."