5 Regulatory Questions for Federal Reserve Chairman Jay Powell

Federal Reserve Chairman Jerome Powell arrives for a news conference in Washington, D.C., September 2018.

This week, Federal Reserve Chairman Jay Powell will testify before the U.S. Senate Committee on Banking, Housing, and Urban Affairs and U.S. House Committee on Financial Services on the state of the U.S. economy and the Fed’s current monetary policy stance. Beneath the topline economic numbers, which continue trends that started a decade ago, wage growth remains persistently low for workers, and labor force participation rates are lagging behind the levels achieved in the 1990s. Moreover, there are still serious employment and wage gaps for segments of the population, including communities of color, women, workers without a college degree, and workers in rural areas. Instead of supporting policies that would target these employment disparities and raise worker wages broadly, the Trump administration and its allies in Congress have steadfastly supported an agenda that favors the wealthiest Americans and corporations.

The hearings provide an opportunity for lawmakers to ask Chairman Powell about the Fed’s recent financial regulatory actions, which could set the stage for the next financial crisis. For example, the Fed has advanced rollbacks to important elements of the postcrisis financial regulatory framework, including weakening the stress-testing regime, reducing big bank capital requirements, watering down liquidity rules, eroding the Volcker Rule, and more. Together, these changes represent a significant erosion of the safeguards that were put in place to prevent another devastating financial crisis. They leave the banking system less resilient to future stress and increase the likelihood that instability in the financial system will exacerbate the next economic downturn. The Fed’s actions are particularly concerning given the underlying financial risks that are developing as the economy moves toward the end of the business cycle.

Below are five regulatory questions that lawmakers should ask Chairman Powell at the hearings this week.

1. Why is the Fed reducing the loss-absorbing capital requirements for big banks when substantial evidence—and the economy’s position in the business cycle—all point to the need for higher equity buffers?

The 2007-2008 financial crisis exposed severe weaknesses in the regulatory requirements for the largest banks in the country. One of the primary shortcomings was the quality and quantity of bank capital requirements. Big banks funded their assets with too much debt and too little loss-absorbing equity capital. While postcrisis reforms have significantly improved the capital positions of the largest banks in the country, a growing body of research shows that equity levels are still too low. Rather than requiring banks to continue retaining some earnings amid high profits, the Fed and other banking regulators have proposed several regulatory changes that would lower capital requirements for banks with more than $100 billion in assets.

The Fed, along with the Office of the Comptroller of the Currency, proposed reducing the leverage capital requirements that apply to the eight most systemically important banks in the country, known as G-SIBs. The proposed change would lower the capital requirements at G-SIBs’ insured commercial banking units by an estimated $121 billion, or 20 percent. Regulators also proposed allowing banks with between $250 billion and $700 billion in assets—the class of banks that aren’t quite G-SIBs—to opt out of a postcrisis capital requirement that ensures their capital ratios reflect the up-to-date value of certain securities holdings. This change will increase the reported bank capital positions at these banks by $5 billion without actually increasing their ability to absorb losses. And it could have a much larger effect when the financial system is under duress and banks’ securities portfolios lose substantial value. The reported capital positions, and therefore the capacity to absorb losses, at these firms will appear rosier than is appropriate. Less conservative stress-testing assumptions, which the Fed has proposed, would also have the practical effect of lowering capital for banks that are larger than $100 billion in assets but don’t qualify as G-SIBs. The stress tests are, at times, a binding capital constraint for firms of this size.

Furthermore, the economy’s position in the business cycle necessitates increases in equity requirements. One of the lessons learned in the financial crisis—and enshrined in the Dodd-Frank Act—was the need for countercyclical financial regulation. Regulations, and in particular capital requirements, should be strengthened during positive economic times, when underlying risks start to grow and banks have the capacity to retain profits. The Fed’s own Financial Stability Report shows that nonfinancial sector leverage is high; credit quality for corporate debt has deteriorated; and valuations across asset classes are elevated. Now is the time for the Fed to activate the countercyclical capital buffer, an additional equity cushion that would generally apply to banks with more than $250 billion in assets.

2. Given the importance of bank stress testing in the wake of the financial crisis, why has the Fed recently advanced proposals to reduce their stressfulness?

The Fed’s stress-testing regime has been one of the most useful new regulatory tools developed following the financial crisis. The annual exercises help ensure that big banks have enough equity capital to withstand a severe financial shock and economic downturn, while still providing credit to the economy. Stress testing has improved the risk management and capital planning processes at big banks and, along with heightened capital requirements, has led big banks to substantially increase their loss-absorbing equity buffers.

The Fed has decided to significantly increase the amount of information they provide banks on the Fed’s internal stress testing models, which makes it easier for banks to adapt their balance sheets to the Fed’s models and game the tests. Additionally, a Fed proposal would loosen some of the assumptions used in the stress testing scenarios and remove a key bank leverage measure from the tests’ required minimum capital requirements. The Fed’s Vice Chairman for Supervision Randal Quarles has suggested that the Fed might reveal even more information on the stress-testing models and scenarios in the future—and may even remove leverage measures from the tests altogether. Finally, the Fed proposed a reduction in the frequency of stress testing for banks with between $100 billion and $250 billion in assets from annually to every other year, exercising the discretion afforded by the Dodd-Frank rollback bill. These changes undermine one of the most important postcrisis financial stability tools.

3. With the recently announced BB&T-SunTrust merger and the expected wave of banking mergers and acquisitions activity, is the Fed concerned about consolidation in the banking sector?

The merger of BB&T and SunTrust would create the eighth-largest bank holding company in the United States and represent the largest bank merger since the financial crisis. Mergers and acquisitions in the banking sector are expected to increase this year, in part due to the passage of the Dodd-Frank rollback bill and some of the Fed’s regulatory actions for banks with more than $250 billion in assets. Statistics that the Fed provided in response to a letter from Sen. Elizabeth Warren (D-MA) underscore the agency’s permissiveness of mergers over the past 12 years: The Fed approved 3,316 out of 3,819 merger applications, or 86.8 percent, between 2006 and 2017. No merger applications were officially denied, and the remaining applications were withdrawn. During Chairman Powell’s tenure, the Fed has approved merger reviews at an even quicker rate compared with previous years. In advance of the expected increase in merger applications this year, the Fed’s general permissiveness of bank consolidation should receive scrutiny.

4. Given the litany of scandals and hundreds of billions of dollars in fines levied over the past decade, are additional policy interventions required to better improve the culture and accountability in the banking sector?

Since the financial crisis, banks have been fined hundreds of billions of dollars for a litany of scandals, including many that had nothing to do with the type of mortgage fraud that was rampant before the financial crisis. From alleged schemes to rig interest rate benchmarks to money laundering and opening fake accounts, malfeasance in the banking system seems ever-present—but accountability is scarce. Persistent misconduct on Wall Street undermines confidence in the financial system, harms consumers, and violates the promise of fundamental fairness in society. It is clear that current regulatory and prosecutorial approaches are insufficient, and regulators such as the Fed must advance additional policy interventions to improve the culture within the banking sector and mitigate the risk that misconduct poses to the financial system. Regulators should start by finalizing the various executive compensation rules included in Dodd-Frank that remain incomplete nine years later.

5. As a voting member of the Financial Stability Oversight Council (FSOC), do you think that the FSOC should address the risk of growing leverage in the hedge fund sector, including the lack of timely and granular data?

The FSOC, Office of Financial Research (OFR), and the Fed’s own Financial Stability Report have all identified the increase in leverage at hedge funds over the past two years as a possible risk. The hedge fund strategies employing the most leverage have roughly $1.5 trillion in financial exposures, and leverage is concentrated at the largest funds. The failure of a large and highly leveraged hedge fund could pose a threat to financial stability.

The FSOC was created with the passage of the Dodd-Frank Act to identify and mitigate threats to financial stability—especially those that fall outside of the traditional banking sector. The council created a hedge fund working group toward the end of the Obama administration to monitor the hedge fund sector and probe the need for more and better data on potential financial stability risks. The working group has not provided a public update on its work in more than two years, suggesting that U.S. Secretary of the Treasury Steven Mnuchin has shut it down. The need for this workstream has only increased over the past two years with the significant growth in hedge fund leverage. As a voting member of the FSOC, Chairman Powell should push the council to reinstate the hedge fund working group and address these concerns.

Conclusion

The congressional hearings this week offer an important opportunity for lawmakers to hold the Fed accountable for its concerning regulatory decisions. Rolling back the Volcker Rule, making the stress tests less stressful, reducing the capacity for big banks to absorb losses, and other actions increase the fragility of the financial system. These actions could sow the seeds for the next financial crash.

Gregg Gelzinis is a policy analyst for Economic Policy at the Center for American Progress.