Without a supervision chief at Fed, full board owns regulation

With the prospect of adding a new vice chair for supervision this year growing more remote by the day, the Federal Reserve Board could soon find itself in an undesirable position: having to wade into politically choppy waters.

Randal Quarles, the first — and thus far only — person to hold the title of vice chair for supervision, said the role serves as a first line of defense for the rest of the Fed board when it comes to responsibility for the Fed's regulatory policy. Without someone serving in that role, any partisan political attacks that arise from regulatory choices the Fed makes fall on the board more broadly rather than on the vice chair for supervision.

“It's one of the main roles of this job,” Quarles told American Banker in an interview. “The Fed has always had these responsibilities, it's always had an operational framework for [supervision and regulation], but as these issues have become less purely technical and become much more partisan, there needs to be a point person who has this specific expertise on the Fed board and the political imprimatur to take the heat" on controversial issues.

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Created by the Dodd-Frank Act in 2010, the Fed’s vice chair for supervision sets the regulatory agenda for the central bank’s governing body and oversees its supervisory activities.

The role has been vacant since Quarles’s four-year term in the position expired in October 2021. He resigned from the board at the end of last year and has since rejoined the Cynosure Group, an investment firm he helped found in 2014.

Quarles’s departure left the Fed’s staff to hammer out policies on numerous topics ranging from mundane — updating its list of permissible activities for holding companies and foreign banks, for example — to contentious, such as integrating climate change into the supervisory framework and regulating cryptocurrencies. And it must navigate those waters collectively, without a direct point of contact on the board of governors.

And the Fed will soon have to make regulatory choices on issues that will likely face partisan backlash. The implementation of the final components of the Basel III regulatory framework — also known as the Basel III endgame or, Basel IV — is supposed to be complete by the start of next year and will require a recalibration of the Fed’s current leverage capital framework. Quarles said this is the most pressing issue facing the Fed’s regulatory apparatus.

“That's a big thing that's out there that is languishing as far as the lack of a vice chair" for supervision, Quarles said. “At some point, the Fed will want to try to make progress on its international obligations ... but they'll just have to put something out if somebody is not nominated and confirmed.”

The Fed has been considering a change to its supplementary leverage ratio, or SLR, rules since last spring, after the expiration of a temporary change that excluded central bank reserves and Treasury securities from the capital requirement calculation. The amendment was made to boost liquidity during the early stages of the pandemic. After the one-year exemption ended, the Fed acknowledged that the growth in central bank reserves and Treasury securities could warrant a permanent modification to the SLR to avoid undermining financial stability.

Quarles argues the current calibration is pushing deposits out of the banking system and into riskier investments, such as money market funds. Yet, he acknowledges that any changes to the leverage capital framework is politically divisive, with many progressive voices calling for stricter capital requirements. This debate, he said, is why it is important for contentious changes to be led by an appointee with both the White House’s backing and Senate’s approval.

“In the absence of someone in that role, the Fed will have to make these decisions,” Quarles said. “They can’t avoid the fact that there's a deadline at the end of this year to propose the implementation framework for the Basel III endgame. They can't avoid the fact that our leverage capital framework is calibrated too tightly for the smooth functioning of the Treasury markets.

“The Fed will have to deal with that, and the ire from either side that comes in response to that will have to be absorbed by the whole Fed.”

Leading the way

The Biden administration’s pick to replace Quarles, Sarah Bloom Raskin, a former Fed governor and deputy secretary of the Treasury, asked for her nomination to be withdrawn on March 15 after Sen. Joe Manchin, D-W.Va., said he would not support her. During her confirmation hearing in the Senate Banking Committee, Raskin faced intense questioning from committee Republicans, who argued that Raskin’s past statements arguing for the Fed to bar energy companies from emergency credit facilities were disqualifying.

With midterm elections looming and a host of other nominations to work through the Senate confirmation process — including Biden’s four other Fed picks, who are due for a final vote later this month — time is running out for the administration to get a vice chair for supervision confirmed.

In the meantime, the Fed’s supervision and regulatory duties are being executed entirely by the Fed's career staff. Day to day, this includes monitoring banks to make sure they meet capital requirements, designing this year’s stress test and reviewing bank mergers.

Former Fed Gov. Daniel Tarullo, who chaired the board’s supervision and regulation committee before the vice chair for supervision was established, served as the closest approximation to a vice chair of supervision during the Obama administration, which never put forward a nominee. He said the staff appears to be operating well without a point person on the board, but he noted there is a difference between operating under such conditions for a few months and doing so for more than a year.

“There was a reason why Congress wanted that person to be publicly specified in the post-financial-crisis period,” Tarullo said. “I certainly think it's important to have someone in that role, providing the leadership to staff and serving as the focal point of the members of the board on this point.”

Quarles is less sanguine about the staffers operating without a board member checking their work. Before his tenure as vice chair, the staff’s supervisory actions were often “arbitrary and capricious,” he said, adding that he’s worried they have reverted to such practices since he left.

“Supervision used to be just a bank examiner going in and making sure there was enough cash in the vault according to the accounting statement,” Quarles said. “Now, it's so much more and so much more consequential for these firms under the rubric of supervision, which is not limited by the due process constraints that we hold so critical for regulation.”

Setting the agenda

Previously, the Fed’s staff would report regularly to the board’s committee on supervision and regulation. But that group has been whittled down to one member, Gov. Michelle Bowman, who is the Fed's community banking representative. During his press conference after last month’s Federal Open Market Committee meeting, Fed Chair Jerome Powell said the committee is not active but the board is “making do with the situation we have” on its legal regulatory obligations.

For now, supervision and regulatory staff report directly to the board as a whole, but only for matters that require a full board vote — final decisions, such as merger applications. Otherwise, Powell would have full discretion over what new initiatives are brought to the table, Derek Tang, co-founder of the Washington-based research firm Monetary Policy Analytics, said.

“In the absence of" a vice chair for supervision, Powell "has to take on some of that responsibility,” Tang said. “For big issues, I don't suspect that they're going to try to deal with those before they get a new vice chair. But there are some things that are outstanding, which are quite important.”

Tang noted the SLR update as well as the annual vote on whether to activate the countercyclical capital buffer — which was last considered by the board in late 2020 — as two areas that might necessitate more immediate action.

Recent additions give an indication of the Fed’s preexisting priorities for its staff. Last year, before Quarles stepped down, Mike Gibson, director of the Fed’s division of supervision and regulation, hired Kevin Stiroh, the then-head of the New York Fed’s supervision group. Stiroh was brought in to lead a new, systemwide committee to evaluate the financial risks of climate change.

Outside forces can also have a bearing on the Fed’s policymaking. Because its staffers work closely with their counterparts at other bank regulators, interagency initiatives — such as the White House’s executive order calling for an all-of-government examination of digital assets last month — can influence what gets prioritized.

On the other hand, the cooperative nature of the banking agencies could multiply the negative implications of the vice chair for supervision role going unfilled, said Jeremy Kress, an assistant professor at the University of Michigan and a former attorney for the Fed’s banking regulation and policy group.

“There’s really pressing work to be done on climate financial risk, on stress-testing reforms, on bank merger policy. That work is not going to get done without the vice chair for supervision,” Kress said. “A lot of these initiatives are likely to be interagency initiatives, so the FDIC and OCC may be in a bit of a holding pattern on some of these issues until the Fed is ready to come along. So this vacancy is affecting not only the Fed but also the other banking agencies.”