Fed shouldn't have to remind large banks about managing obvious risks

With the recent departures of Federal Deposit Insurance Corp. Chair Jelena McWilliams and Federal Reserve Vice Chair for Supervision Randal Quarles, banking supervision and regulation are likely to get strengthened. That would mark the end of the Trump-era’s much discussed deregulation and, too often, non-regulation and nonenforcement. In addition, banking supervision, which is rarely publicly mentioned, is also going to be revived.

That can’t happen soon enough given a recent, incredibly important but mostly unreported red flag: late on a Friday afternoon in December, the Fed issued an unprecedented supervisory letter chastising Wall Street’s biggest banks regarding their market risk management failures, highlighted by the Archegos family office debacle. The Fed’s findings reflected in that letter were also highlighted at a Feb. 4 meeting of the Financial Stability Oversight Council.

The letter purported to remind firms of the supervisory expectations related to the management of risks in facilitating large market transactions like Archegos’s multiple, concentrated, leveraged positions. This reminder came nearly nine months after the Archegos failure, which caused more than $10 billion in losses at several banks and about $200 billion in market cap losses for shareholders in the targeted stocks.

The areas of supervisory guidance the letter emphasizes are fundamental risk management expectations, such as risk identification, due diligence of clients, and corporate governance — areas around which large banks already should have full awareness. It is telling that the Fed believed it needed to remind the biggest banks in the country of their responsibility to identify and manage such obvious risks. The letter indicates that the Fed found widespread deficiencies across a number of large banks.

In fact, bank losses, especially in the U.S., would have been much greater if Goldman Sachs and others didn’t race to sell their collateral before other market participants learned of Archegos’s dire condition. That is, their loss mitigation was not based on having robust and ongoing risk management practices, but rather on the luck of being the first to sell. (In addition, those banks are now reportedly under investigation for potentially tipping off hedge fund clients to the block-trade sales, enabling the hedge funds to also sell before the public and accelerating the drop in share prices.)

This conduct is clear evidence that supervision of the largest banks was weakened over the past four years, despite Quarles’s claim in his parting speech that increased transparency made supervision “stronger now than it was four years ago.” That should not be a surprise given his prior admission that “changing the supervision culture ‘will be the least visible thing I do and it will be the most consequential thing I do.’ ” To accomplish that, The Wall Street Journal reported that he and McWilliams “spent several months touring the country, visiting bank examiners in regional offices and asking them to adopt a less-aggressive tone when flagging risky practices and pressing firms to change their behavior.”

As intended, bank supervisors got the message and banks, as The Wall Street Journal put it, got the “kinder, gentler treatment” Quarles and McWilliams wanted.

This orchestrated erosion of effective supervision was compounded by regulatory changes during the Trump administration. While the overall framework of the post-2008 financial crisis reforms was left largely intact during the Trump years, there was nonetheless significant deregulation that seriously weakened its foundation. This created an environment that almost encouraged the type of recidivist behavior large banks have exhibited before and since the 2008 collapse.

Additionally, a key part of effective risk management and greater resiliency at large banks is having clearly adequate levels of capital to absorb losses. After all, the only thing standing between a failing bank and a taxpayer bailout is the quality and quantity of the bank’s capital cushion.

Yet, during the Trump era, the stress testing of large banks was significantly weakened, as were the capital thresholds associated with it. Despite this, both Quarles and McWilliams claimed that capital levels are “more than ample” and “robust.” To support this claim, they pointed to the fact that the large banks didn’t fail or need bailouts during the pandemic, and Quarles also pointed to the results of last year’s stress tests. Neither point, however, serves as support for their claims.

First, comfort should not be taken because banks didn’t fail during the pandemic. Large banks, like small banks, other financial firms and corporate entities of all types survived the pandemic without failing because the Fed flooded the financial system with more than $4 trillion in “liquidity,” which could be viewed as an economywide bailout.

Moreover, that unprecedented Fed support was supplemented by trillions of dollars of equally unprecedented fiscal support and loss mitigation from legally provided mortgage and other loan forbearance. The entire point of that overwhelming support was to prevent any entity from failing, and all entities, including banks, greatly benefited from that aid.

Second, it is also no comfort that the banks passed last year’s stress tests, which had been seriously weakened by the Fed under Quarles’s leadership during the pandemic. Indeed, there was a 100% pass rate, which is more of an indication of a lack of serious stress testing than of bank strength.

Quarles’ claim that a primary objective of banking supervision and regulation was to make it “more simple, more efficient” rather than more effective reveals his fundamental misunderstanding of the role of supervisors and regulators. For example, lowering capital is a longstanding, constant goal of the banks, but sufficient capital is imperative to protect taxpayers, the financial system and the economy at large.

There are many ways to judge success or failure, but the fact that the Fed believed it had to send a letter to the biggest banks reminding them of their most basic market risk management responsibilities is a clear indication of failure, not success. That it took trillions of dollars in financial and other support to prevent a collapse of the financial system when the pandemic hit may not prove they were undercapitalized, but it certainly doesn’t prove they were adequately capitalized.

With Martin Gruenberg taking over for McWilliams at the FDIC as acting chair, a replacement coming soon at the Fed for Quarles and Mike Hsu serving as acting comptroller of the currency, the country once again has regulators who believe in genuinely effective banking supervision and regulation. They have a lot to do. They should disregard the parting comments of Trump’s regulators, reverse their most dangerous deregulation, reinvigorate supervision and get serious about addressing future risks from poor risk management.