Yesterday, FRB Gov. Powell said that the Fed will “reset” its standards for what boards of directors must know and do better to align these expectations with the strategic obligations usually considered a director’s principal responsibility. Many have talked about the benefits of regulators with a business background. This Powell reset is a sharp departure from the Tarullo regime and clear evidence of the benefits of having actually once worked as a banker and director. Academic insights are vital, but the real world makes a bit of a difference too.
Mr. Powell’s discussion was general in nature. I hope the Board will quickly reset the governance meter on all of the rules promulgated under Section 165 of Dodd-Frank – that is, the capital, liquidity, risk-management, and stress-test standards that each demand both far too much detail-mastery from bank boards of directors. At the same time, I urge the Fed to finish one unfinished piece of Dodd-Frank business: early-remediation standards. It’s ironic that regulators have worked so hard for so long on everything bankers have to do and left undone for seven years the one thing Congress told them to do and when.
In my expert-witness work, I’ve seen case after case in which regulators waited far too long to make it very clear to directors that the bank had to shape up or face receivership. This was well known in the wake of the S&L crisis, when Congress told the regulators to take “prompt corrective action.” Because regulators didn’t do as they were told, Congress in 2010 tried again with still more stringent early-remediation standards. FedFin’s analysis of this still-incomplete proposal raises some caveats with the specific rule, but the underlying point then and now is that directors can and should be freed from hands-on management if regulators make it immediately clear when directors have to take action or put the bank up for sale or out to pasture.
A forthcoming FedFin study adds another to-do to the list of rules regulators should reconsider in the government reset Mr. Powell promises. This is the advanced-approach capital rules promulgated in concert with other U.S. Basel III standards. The relationship between the advanced and standardized approaches is of course a contentious question – see our forthcoming paper for more. One important fact is, though, easy to understand: in the U.S., large banks must hold the highest of the standardized or advanced rules, not the lowest possible regulatory-capital charge as allowed by the EU and most other countries.
With this taken into account in the marginal cost-benefit analysis presented in our paper, we conclude that the advanced approach adds very little prudential value. In fact, as we show, it may well make banks riskier precisely because of the burden these complex standards place on boards of directors. Running down each model as all of them are required to do may well leave directors ignorant of important, underlying trends. Supervisors are even more likely to be distracted from early warning signs by complex models and compliance questions.
Set safety-and-soundness standards appropriately for a bank’s complexity, so that directors can understand them, let management govern the complexities needed to achieve substantive compliance, and ensure supervisors look for trouble and act quickly when they find it. That’s my recipe for a reset.