Policing banks' 'conduct risk' should be a formalized regulatory duty

The United States should add a conduct risk authority to its current bank regulatory system. The benefits of such an authority include reducing the likelihood of a banking crisis by adopting conduct risk scores for "too big to fail" banks and fostering investor confidence for continued investment in the financial system, particularly in smaller banks.

Lawmakers have also proposed an independent inspector general to monitor the Federal Reserve Board and the Consumer Financial Protection Bureau (CFPB) in light of recent bank failures. There are now additional reasons for adopting such a system. The recent positive outcomes from the Federal Reserve's stress tests conducted on 23 banks brought much-needed reassurance to the markets, given the bank failures earlier this year. But while these outcomes appear encouraging, it may be premature for the markets to bask in these results. Notably, in 2022, before the 2023 bank failures, the Fed asserted that large banks were well-capitalized and equipped to endure economic shocks. Despite this, several banks subsequently experienced significant difficulties.

Acknowledging this last month, Michael Barr, the Fed's vice chair for supervision, announced plans to spearhead an initiative aimed at revamping bank supervision across the Fed. In a speech he made in Washington, D.C., Barr described plans to beef up capital standards for a broader range of banks. Likewise, all banks above a certain size threshold would need to account for certain unrealized portfolio losses in their regulatory capital calculations.

Supporting Barr's initiative, Michael Hsu, the acting Comptroller of the Currency (OCC), confirmed that regulators are aligned on rule changes, adding that forthcoming policy proposals are being driven by more than the 2023 bank failures. Similarly, recently federal regulatory agencies updated their liquidity risk and contingency planning guidance for banks, urging depository institutions to regularly revise their plans and incorporate the discount window.

Also focusing on banks' supervision, Fed Governor Michele W. Bowman, in a speech delivered in Austria, called for an independent third party to analyze the events surrounding the recent bank failures to fully understand the relevant circumstances. Bowman noted that the Federal Reserve report on the topic was essentially the product of a single board member and had not been reviewed by others before being publicized. She suggested a supplementary, independent review that could address the issues of scope and timing, noting that additional independent reviews could significantly enhance understanding of the situation. She also highlighted that future regulatory requirements from the central bank should prioritize supervision and liquidity over capital requirements.

Addressing some of the current weaknesses in financial regulation and supervision, several news sites mentioned how venture capitalists also reaped benefits from FDIC funds when Silicon Valley Bank collapsed. Regulators, considering the broader implications of the crisis, decided to compensate depositors beyond the basic FDIC guarantee, thereby maintaining financial stability. However, there is an apparent internal discord within the Fed regarding the strategy for future bank supervision. Considering this, regulators should seriously contemplate the establishment of an independent conduct risk authority in the U.S. The role of this authority ought to extend beyond just a handful of "too big to fail" banks.

Three additional reasons support the creation of such an independent authority. First, the disagreement between the Fed and banking regulation senior officials about supervising and regulating banks, as mentioned above, might point to the need for creating a third party, as Governor Bowman indicated.

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Second, the Federal Reserve report shows how exposed financial institutions are to commercial real estate debt. An independent, unaffiliated watchdog institution whose sole purpose is to examine banks' conduct risk could help ensure this by consistent monitoring.

Finally,  Treasury Secretary Janet Yellen's recent comments — in which she mentioned that the U.S. should expect the dollar's share in global reserves to decline slowly — touched upon some banking risks that require significant monitoring and attention. As Secretary Yellen stated, "[t]here is a very good reason why the dollar is used widely in trade, and that's because we have deep, liquid, open capital markets, rule of law and long and deep financial instruments." But what was left unsaid is that much like its currency, the U.S. also has a long history of being a jurisdiction that provides for deep, liquid and open capital markets via regulation, supervision and enforcement.

To uphold this reputation and its advantageous position in the financial industry, the U.S. must devise strategies to ensure its commercial banking system stays ahead of those in other countries. A conduct risk authority might just be the answer to the ethical, trust and integrity issues endemic to the financial sector. Financial institutions have an entire ecosystem of internal controls and measures to identify, assess, monitor and control these risks. Yet violations of their customers' trust continue. The most recent CFPB and OCC fines and penalties accrued to Bank of America are illustrative. "Bank of America wrongfully withheld credit card rewards, double-dipped on fees, and opened accounts without consent," CFPB Director Rohit Chopra said in a statement. "These practices are illegal and undermine customer trust. The CFPB will be putting an end to these practices across the banking system." While laws and regulations are designed to root out such practices, more can be done.

Financial institutions will continue consolidating as interest rates rise — leading to ever more complex models and "too big to fail" institutions. This increasing complexity, combined with the recent impotence of regulatory supervisory models, is more evident than ever, given the recent bank failures. A vast array of analyses conducted by regulators and independent parties are striving to identify what went wrong. However, the answer is simple. Customers lost trust in Silicon Valley Bank — and technology allowed them to move their money quickly. Trust is the key. The OCC's recent survey of Trust in Banking is illustrative. Trust is a societal and individual good. It is quantifiable, like good will. Technology has allowed immediate association and disassociation with corporations — consumers are empowered as ever. An independent conduct risk authority will provide society with real-time evidence and ratings on the "trustability" of banks, financial institutions and ultimately all corporations. It's time to change the paradigm.