MNI:Banks Face Tougher Rules Under Biden's Next Fed Vice-Chair

U.S. banks could face higher capital requirements and tougher stress tests while nonbanks may see regulation tightened under the incoming vice chair for supervision at the Federal Reserve, former top Fed officials, regulatory and industry experts told MNI.

President Joe Biden's pick for the Fed's chief regulatory slot when Governor Randal Quarles' tenure ends next month is expected to re-empower the Fed's supervisory function via its leadership role on the interagency Financial Stability Oversight Council down to its daily interactions of supervisors with banks.

Easing supplemental leverage ratio rules for big banks remains on the table as a means to prevent another Treasury market meltdown, but to satisfy key Senate Democrats like Elizabeth Warren and Sherrod Brown, the incoming regulation head will need to compensate by tightening requirements elsewhere, perhaps by raising a risk-adjusted capital buffer.

But other changes could be equally important. Whereas Quarles preferred consulting with banks on stress test scenarios in the interest of transparency, fellow Fed Governor Lael Brainard -- the front-runner to succeed him -- would reprioritize the tests and favor more supervisory discretion.

ROLLING BACK DEREGULATION

Brainard could also be expected to wish to reverse some of the 23 regulatory policy changes on which she has dissented since 2018 -- including a relaxation of the Volcker rule prohibition on proprietary trading, easing swap margin requirements and certain adjustments to stress tests . She has also been critical of mergers of medium-sized banks and some acquisitions.

"if we're looking at a Chair Brainard, that would be the first goal coming out of the gate, to clean up some of the bad stuff that happened over the past four years," said former Fed lawyer now University of Michigan professor Jeremy Kress.

Democrats hope their pick might also take up long-unfinished projects including finalizing a Dodd-Frank rule to restrict big bank executives' pay in the event of significant losses and other rules governing affiliate transactions and commodities activities.

NONBANK AND CLIMATE RISKS

Taking action on nonbanks and climate change are also high on priority lists for Democrats, and the Fed has legal authorities it could use to target these risks.

The central bank can set minimum haircut requirements on nongovernment short-term financing instruments as a way to limit the risk of runs on funding companies, Kress said. Quarles's predecessor Dan Tarullo had started to explore this option, which was left dormant.

"The Fed has been very focused on run risks in the banking system but hasn't to date exercised its authority in the nonbank space," Kress said. "When you have Quarles and Powell out there saying nonbanks are a risk, that provides political cover to do something about it."

On climate change, the Fed can unilaterally impose scenario analyses at the bank holding company level to see how lenders would perform under certain simulations. That would pave the way to climate stress tests with binding effects on capital requirements in the future.

SLR REFORM

The absence of large-scale Treasury market disruption since the Fed allowed the supplementary leverage ratio capital exemption on banks' holdings of government bonds and deposits to expire in March has sapped some of the momentum behind SLR reform, but former officials insisted that the issue still needs to be dealt with in the near term.

"The Fed put in a stop-gap to free up banks from holding a lot of reserves by raising the rate it pays on reverse repos, which allowed the money funds to attract deposits from the banks," former Fed Vice Chair Don Kohn told MNI. "It's a workaround that helps, but it makes me a little uncomfortable that the way to deal with the leverage ratio is to make money market funds grow."

Kohn proposed at last month's Jackson Hole Fed conference that the Fed couple an easing of the SLR with an increase in the countercyclical capital buffer to above-zero during normal times. Brainard has also advocated for more active use of the CCYB in the past.

"People like me would say, we should essentially defang the leverage ratio, but not at all at the expense of weakening overall capital requirements, former Fed Governor Jeremy Stein told MNI.

"We'd make a compensating adjustment, maybe torque up the risk-based so that you're very careful you don't have less overall dollars of capital in the system. So there's a way to do it that's absolutely capital hawkish but technocratically smart."