Speech by Governor Bowman on tailoring, fidelity to the rule of law, and unintended consequences

Tailoring as a Grounding Principle

I have long been a proponent of tailoring and continue to consider it a strong foundational principle upon which to apply bank regulation and supervision. This approach ensures a focus on the most critical risks over time, avoiding the over-allocation of resources or imposition of unnecessary costs on the banking system. When we approach rulemaking with a commitment to tailoring, and to our broader prudential mandates, the public can judge our actions by how well they serve these ends, and they should rightly be concerned when regulatory actions seem to serve other goals. In this sense, tailoring keeps policymakers grounded and facilitates appropriate prioritization. Tailoring also allows us to allocate limited supervisory resources to most effectively support safety and soundness of the banking system and U.S. financial stability.

In accordance with the law, the Federal Reserve, both in its monetary policy function and in the execution of its bank regulatory and supervisory responsibilities, is meant to operate independently and apolitically. But banking regulators have a responsibility to act in a way that proves this independence is warranted. We earn the right to operate with this independence when we consistently follow the law and achieve our prudential objectives. One of the most effective ways we accomplish this goal is through the appropriate prioritization of risks in the financial system. Regardless of the approach to bank regulation and supervision, bank regulators should be subject to oversight and accountability, to both Congress and the public.

Does Tailoring Need a Defender?

I suppose one could view my support for tailoring as merely setting up a straw man; surely everyone agrees with tailoring in principle? On a superficial level, it is hard to argue with the principle that regulatory tailoring—matching regulation and supervision to risk—is a prudent approach for bank regulators. And yet the rhetoric supporting tailoring and risk-based supervision often does not match regulatory reform efforts or supervisory approaches. The criticisms rarely manifest as skepticism of the principle itself. Rather, they are implicit in the approach to regulation and supervisory guidance or are disguised as a criticism of the execution of tailoring.

Both the pending capital reform proposals and the final climate guidance illustrate how regulatory actions can deviate from the principle of tailoring without any express recognition of this effect.

If you superimpose the pending capital reform proposals on the table, there is a “flattening” of requirements in the capital bucket. Of course, this simple exercise does not reflect the unknown end state of the bank regulatory framework, and the current desire among some policymakers to modify liquidity requirements. These individual efforts highlight the hazard of piecemeal reforms, especially those that are closely related in their end-state operation, like capital and long-term debt requirements. When regulators pursue reforms by creating separate rulemaking silos, we limit our capacity to not only ensure fidelity to tailoring but also fidelity to our prudential mandates. Even when proposals have concurrent comment periods, the danger is that the final regulations will be miscalibrated and not appropriately tailored.

The content of the guidance—and its expectations for larger banks—suggests that the motivation behind the principles is neither prudential considerations nor to further regulatory tailoring, as it has a somewhat tenuous connection to core safety and soundness considerations and seems destined to trickle down to smaller firms over time. Banks have long been exposed to climate- and weather-related financial risks and have long been required to manage all of their material risks, including these. But the principles seem oriented toward contributing to a policy matter that extends well beyond prudential bank regulation—namely how the U.S. and other governments around the world should address climate change. And the principles seem focused on highly uncertain risks well outside the normal temporal horizon of a bank supervisor. One could reasonably ask, do the principles result in appropriate, risk-based prioritization of supervisory concerns? It is possible that they prioritize risks that may not be the most relevant for safety and soundness and may effectively influence credit allocation decisions through regulations that are not driven primarily by prudential considerations.

Bank regulators can acknowledge the importance of questions around climate change while also hewing to their statutory responsibilities. Promoting safety and soundness and U.S. financial stability is a weighty enough task without taking on other causes.

The current regulatory agenda includes many other examples where similar arguments can be made that regulatory reform proposals lack sufficient attention to regulatory tailoring and thereby fail to further statutory directives to tailor certain requirements and, more importantly, to address the condition of the banking system.

As I have noted many times in the past, I find little evidence to support this claim. While couched as a critique of the execution of tailoring, this argument also seems to challenge the value of tailoring, asserting that a simple solution would be to unwind regulatory tailoring and eliminate risk-based tailoring in supervision. Taking ownership and accountability of the supervisory issues that significantly contributed to the banking system stress last spring enables us to look critically at the approach to regulation and supervision in the lead-up to these failures, and appropriately address the shortcomings.

One critique of tailoring may be with what underlying “problem” it is designed to solve, particularly as it relates to the allocation of finite resources both for banks and for regulators. Are regulatory and supervisory resources actually limited, and if so, what are the practical constraints on these resources? At a basic level, the quantum of regulatory and supervisory resources is a policy decision—as regulatory and supervisory demands grow, so too can the staffs and budgets of the federal banking agencies. The U.S. financial system is expansive and regulators have the capacity to expand supervisory resources as needed (or as perceived) to address safety and soundness concerns.

Of course, there are practical constraints on an ever-expanding and stricter bank regulatory framework. First, the funding of regulatory and supervisory expansion imposes costs not only on U.S. taxpayers but also on banks, and indirectly, bank customers. While the banking system has many advantages—including the use of insured deposits as a source of financing banking activities—at some point, this structural advantage will erode under the cumulative burden of the regulatory framework and will result in a shift of activities from banks to nonbanks and the broader shadow-banking system. The contours of the financial system, where products and services are offered, does not exist according to the bright line of federal regulatory authority. We would be well served to recognize the limitations of a regulatory perimeter that pushes activity outside of the banking system and beyond this authority.

Unintended Consequences

As we consider the merits of tailoring, we should consider the consequences of not adhering to this principle in regulation and supervision, and related reform proposals.

As a threshold matter, a bank regulatory approach that disregards tailoring can manifest in different ways, such as uniformity in approach—failing to differentiate among institutions based on their size, risk, and complexity—or by adopting regulatory “cliffs” clustered around thresholds that insufficiently distinguish among institutions based on these factors. In both cases, deviating from tailoring could result in fundamental changes to the structure of the U.S. banking system.

One risk of uniform requirements is the consolidation pressure it creates. Apart from the shortcomings I’ve discussed in appropriate risk-based prioritization within the bank regulatory framework, this approach encourages consolidation, as institutions seek operational economies of scale to gain competitive advantage over their peers. In this scenario, the benefits of being large, risky, and complex become a driving force in the organization of the banking industry. I think we should consider the implications not only for regulatory efficiency, but also whether this approach represents waving the white flag in fighting against the assertion that certain institutions are “too big to fail.”

Even where standards are not uniform, a lack of sufficient tailoring can reshape the banking industry, simply through the cliff effects created around particular regulatory thresholds. For example, capital reform and climate regulation would establish $100 billion as the key regulatory threshold, lending additional gravity to the decision to cross, or even approach it, with the consequence of reducing the number of institutions around that threshold. Institutions above the threshold will face strong incentives to grow larger to achieve economies of scale. Institutions below the threshold will face strong incentives to manage their size to avoid the significant intensification of requirements that apply as they approach $100 billion in assets. This scenario also has significant implications for the too-big-to-fail issue, as well as for industry competition over the long term.

Regulatory costs that are disproportionate to a firm’s risk create incentives for activities to migrate out of the banking system entirely, which we have seen as a consequence of past regulatory reform efforts. In my view, implicit in the statutory mandate to promote safety and soundness, and financial stability, is that we allow banks to continue serving their role in the U.S. financial system and in support of the economy. Fidelity to the law does not require regulators to create a bank regulatory framework that eliminates risk: banking is inherently about managing, not eliminating, risk.

Closing

Thank you, again, for the invitation to speak with you, and I look forward to our discussion.