NY Fed President Highlights Supervisory Objectives for Complex Financial Institutions

New York Federal Reserve Bank President William Dudley described the current state of supervision over large, complex financial institutions. At a conference of regulators on the subject, President Dudley stated that supervision of large financial institutions is guided by two key objectives: (1) enhancing the resiliency of a firm to lower the probability of its failure and (2) reducing the impact on the financial system in the event of failure or material weakness. He asserted that because “[t]he activities and practices at large, complex financial organizations are simply too intricate and evolve too quickly to be fully described ex ante in regulation,” banking supervisors collect information through examinations and analysis, and “the ultimate responsibility for risk identification and risk management remains with the supervised institution.”

President Dudley stated that the Federal Reserve instituted three major horizontal evaluations which are a key part of the new enhanced supervisory framework for large banking companies: (i) the Comprehensive Capital Analysis and Review, which applies to firms with at least $50 billion in total assets and assesses capital adequacy, (ii) the Comprehensive Liquidity Analysis and Review, which examines the liquidity positions and liquidity risk management of large, complex banking organizations, including internal stress-testing practices, and (iii) the Supervisory Assessment of Recovery and Resolution Preparedness which provides an annual evaluation of the firms’ options to support recovery and progress in removing impediments to orderly resolution. President Dudley posed the following question regarding the supervision effectiveness: “If a bank fails, is this evidence of poor supervision, or instead evidence that even good supervision can’t prevent all bank failures? Improving our ability to do this diagnosis is critical.”

In a panel discussion on defining the objectives of supervision, FDIC Vice Chair Thomas Hoenig asserted that (i) big banks should be subject to a more detailed examination process, (ii) banks should provide a fuller disclosure of any financial difficulties that they may be having to the public “at an earlier stage,” (iii) bank capital requirements should be higher, and (iv) capital adequacy should be based on tangible equity rather than on risk-based capital.  He also stressed the importance of bank regulators not backing down to industry pressures, citing the example of when regulators questioned the viability of commercial real estate leading up to the 2008 crisis, but succumbed to industry pressures.

Lofchie Comment: Taken together, these speeches seem to be calling for regulatory supervisors to have greater authority with less responsibility. It is a call for greater power yet an attempt to pre-avoid blame in the event of market failure since “the ultimate responsibility for risk identification and risk management remains with the supervised institution.” It is easy to be left with the impression that the regulators are not inclined toward self-criticism. In this regard, the worst that Mr. Hoenig can find to say about the bank regulators is that they were insufficiently confident of their own correctness as to the state of the commercial real estate market in 2006 and 2007. Perhaps, then, a good challenge for Mr. Hoenig would be to go back and look at the predictions of bank regulators over the last twenty or thirty years, and to see how well they have fared. Maybe it will turn out that the bank regulators are routinely smarter than the markets, but maybe it won’t. To be cynical, predicting that many things may go badly, and, sometimes, being correct, does not require any remarkable skills (lawyers are in fact quite good at that).