Fed Supervision: DC in the Driver’s Seat

On April 17th, the Board of Governors of the Federal Reserve System (“Fed”) issued a better-late-than-never Supervisory Letter, SR 15-7, describing its governance structure for supervising systemically important financial institutions under its so-called Large Institution Supervision Coordinating Committee (“LISCC”). [1] Though much of the structure has been in place for years, the Fed had not publicly explained in detail its supervisory process, leading some in Congress and elsewhere to criticize its secrecy.

For firms accustomed to interacting with Fed staff inside this structure, the Letter’s detail is not news. But for others, including many Fed critics, the Letter does shed some new insight with its formal description of the activities and subcommittees of the LISCC. The need for more transparency in this area has likely become clearer to the Fed, as it strives to demonstrate that it is responding to Congressional concerns [2] and that the agency’s supervision of the largest banks is appropriately stringent.

Overall, the Letter describes a system-wide structure that has evolved since the crisis, led by officials in Washington, to harness the expertise of traditional supervisors and other Fed economists to evaluate both the safety and soundness of large, systemically important financial institutions and their impact on financial stability more broadly. The Fed’s teams look at practices both within and across institutions in order to understand leading practices and develop more consistent assessments of and messages to firms.

This post analyzes the contents of the Letter and, as importantly, what was left out.

Background and Analysis

The LISCC was established by the Fed to coordinate supervisory efforts across the largest Fed-regulated systemically important financial institutions by bringing together more points of views from various disciplines within the Federal Reserve System (e.g., banking supervision, payments systems and economic research).

Although supervised firms have been overseen by the LISCC since its inception, direct interactions have been largely limited to on-site, dedicated teams. The Letter’s description of the LISCC structure for the first time provides a view of the extensive system that drives evaluations of supervised firms, leading to several noteworthy observations.

First, the Letter makes it clear that the Fed’s Director of Banking Supervision and Regulation, who chairs LISCC, is a key decision-maker in the supervisory process and accountable to the Board of Governors. This marks the continuing trend of shifting authority from local, dedicated supervisory teams to Washington. In fact, the structure articulated within the Letter shows that firm-specific supervisory teams play a more limited information gathering and execution role, and that recommending supervisory ratings related to specific risk types (e.g., credit, market, and liquidity) and even vetting the Fed’s communications with the firms are left to centralized LISCC subcommittees run by Washington. In reaction, supervised firms should foster stronger relationships with officials in Washington while maintaining their existing relationships with local Fed supervisory teams.

Second, the Letter confirms the Fed’s cross-firm approach to supervision of the largest institutions—i.e., one in which risk assessments and decisions are made based on a horizontal look across this group of entities rather than only at each individual firm. The Letter then goes one step further by making clear that this cross-firm approach goes beyond particular supervisory exercises (e.g., CCAR stress testing) to include the complete range of regulatory rules and expectations governing the largest institutions.

Third, the Letter implies that LISCC-related efforts will be taken into consideration as the Fed sets its monetary policy. By highlighting the LISCC’s use of information provided by the Quantitative Surveillance group and Systemic Risk Integration Forum, both of which include staff who traditionally support the Federal Open Markets Committee, one can safely bet that information flow is going in both directions. The LISCC’s cross-firm approach will likely contribute to monetary policy decisions by offering a view of emerging trends and risks across large institutions that play a significant role in the US financial system.

Open Questions

While the Letter outlines the analytical role played by various LISCC substructures, the Fed largely remains silent on several key issues.

First, the delegation of decision making and accountability for supervisory actions (e.g., CCAR outcomes), including the roles of individual Governors is not articulated. Chair Yellen has been eager to increase the Governors’ involvement in the supervisory process, as evidenced by the Fed’s regular bi-monthly supervision meetings, which started last year. Although it remains to be seen how successful this effort will ultimately be, institutions should consider engaging the Governors and expect them to be aware of more firm-specific details than they may have been in the past. What is even less clear is how increased involvement by the Governors will be balanced with their role as independent overseers of the supervisory process. Those who are actively engaged in direct supervision may find it difficult to independently review their own efforts.

Second, it is unclear how the Fed will extend its cross-firm supervisory approach to incorporate FSOC-designated insurers. While a cross-firm approach to supervision may seem plausible for banking organizations with generally similar activities and risks, the Fed’s application of such an approach to insurers will be challenging due to the extent to which their risk profiles differ from banks. Furthermore, if insurers are treated separately, the benefits of cross-firm supervision are less obvious, given the group will include at most three institutions (at least for the near-term).

Finally, the degree to which changes in the supervision of large institutions will impact the Fed’s approach to non-LISCC firms remains unclear (e.g. for those institutions with greater than $50 billion in assets subject to enhanced prudential standards [3]). We have already seen the Fed’s expectations and processes around individual supervisory programs such as CCAR trickle down from LISCC to non-LISCC firms. Therefore, although the Letter does not answer this question, we believe this trickle-down effect will be expanded to many other of the Fed’s supervisory processes (such as its Comprehensive Liquidity Analysis and Review).

Endnotes:

[1] The LISCC supervises the 12 largest domestic and foreign banking organizations operating in the US, as well as the four nonbank financial companies designated as systemically important by the Financial Stability Oversight Council (“FSOC”) (see PwC’s Regulatory brief, Nonbank SIFIs: FSOC proposes initial designations—more names to follow (June 2013)). SR 15-7 builds on the Fed’s 2012 Supervisory Letter on this topic (SR 12-17/CA 12-14).
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[2] Last year’s Republican victory in the US Senate has only placed the Fed in a more defensive position with respect to accountability and transparency. See PwC’s First take, The New Republican Senate (November 2014).
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[3] See PwC’s First take: Enhanced Prudential Standards (February 2014, discussed on the Forum here).
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