Update 304: Fed Developments – Nominations and Rules;
How Trump is Shaping Financial Regulations
On September 26, far away from the Kavanaugh maw, the Federal Open Market Committee (FOMC) voted to raise the target range for the federal funds rate from 2 to 2.25 percent. The market expects one more rate hike this year, three increases in 2019, and one in 2020. During the press conference after the interest rate announcement last week, Federal Reserve Chair Jerome Powell remarked on the record low unemployment, robust economic growth, low and stable inflation, and modest wage growth as the backdrop to the FOMC decision to raise rates.
While the Fed’s monetary policy updates may be predictable at this juncture, other developments at the Fed, including some notable nominations and concerning rulemaking proposals are detailed below.
Republican obstructionism during President Obama’s tenure gave President Trump the opportunity to appoint six of the seven Fed Governor seats, all of whom serve 14-year terms. The administration is targeting the Dodd-Frank framework, so these nominees and their ideological positions are crucial in charting the Fed’s deregulatory agenda. There are three remaining Board seats to be filled with Fed Chair Jerome Powell and Vice Chairmans Randal Quarles and Richard Clarida appointed under the current administration.
- Richard Clarida
Richard Clarida was sworn in last month as Vice Chairman and member of the Fed Board of Governors after a 69-26 vote in the Senate. During his Senate Banking Committee confirmation hearing, Sens. Warren and Cortez-Masto both expressed concerns about his views on regulation, specifically capital and liquidity requirements. Clarida responded by expressing his support for tailoring — the new euphemism for deregulating — post-crisis banking rules in order to make the financial system more “efficient” without increasing systemic risk.
- Marvin Goodfriend
Conservative economist Marvin Goodfriend was nominated to the Federal Board of Governors in November 2017 and has had a halting confirmation process. Backed by establishment conservatives but disliked by libertarian-leaning Republicans and Democrats, Goodfriend is an inflation hawk and critic of monetary policy instruments, such as quantitative easing. During his confirmation hearing, Goodfriend was narrowly approved by Senate Banking in a 13-12 party-line vote. Many believe that this nomination will not go forward.
- Michelle Bowman
In April 2018, former Kansas Bank Commissioner Michelle Bowman was nominated to the Fed and was approved by Senate Banking in June, 18-7, with five Committee Democrats voting in favor. With her background in community banking, a component required by Congress of at least one Board member, Bowman is viewed as a reasonable and responsible, if conservative, choice. The seat has been empty since 2015, when Obama’s nominee, Allan Landon, was blocked by Senate Republicans. The fifth-generation banker will likely be approved by the Senate in the coming months.
- Nellie Liang
Last month, President Trump nominated former Fed economist, Nellie Liang, to the Fed’s Board. Under former Fed Chair Ben Bernanke, Liang was director of the Office of Financial Stability Policy and Research at the Federal Reserve Board, tasked with identifying weaknesses in the financial system. Liang, a senior fellow at the Brookings Institution since 2017, argued for a preemptive and proactive approach to identifying risk in the financial system in a paper just last week. She would likely bring this view to the Board if confirmed.
Liang’s nomination is curious. Her background in identifying risks in the financial system seems at odds with the ideological views of some of Trump’s other Board picks. Incidentally, Liang is a registered Democrat. There is a history of pairing Fed Board nominations to appoint one member from each party but, so far, Liang’s nomination has not been tied to another candidate. It remains fairly likely that this is the administration’s goal with Liang, so it’s worth watching for additional nominees.
2155 Legislative Intent and Fed Discretion
When Congress passed S. 2155 in May, many members voted to free community banks from prudential standards they considered unnecessary to smaller firms. What some in the GOP wanted, expressed in a letter written by Sen. David Perdue to Quarles on August 17 of this year, was to redefine the entire supervisory regime. They wanted to liberate big banks from the enhanced prudential standards, such as supervisory stress testing, that were enacted to keep too-big-to-fail banks in check.
The stress testing framework in Dodd-Frank was adopted to test the resiliency of financial institutions under hypothetical macroeconomic stress conditions. Even before S. 2155, the Fed had begun proposing rule changes in the name of transparency, which included releasing the modeled loss rates on different groupings of loans and the estimated loss rates on hypothetical portfolios of loans. These changes may encourage firms to tailor their balance sheets to fit in with the stress tests, effectively allowing them to circumvent the supervisory exams entirely.
De Novo Deregulation
The Fed is planning its own de novo rule changes that would loosen regulation on some of the biggest banks. The rules would change how the Fed defines a big bank and what asset sizes require increased regulation. Quarles has called the asset sizes out of date, stating that “it is clear that there is more that can and should be done to align the nature of our regulations with the nature of the firms being regulated.”
The two rule changes, both raising the asset threshold for heightened regulatory oversight to $250 billion and loosening regulations for those that meet it, are focused on:
- Liquidity Coverage Ratio (LCR): Established by Dodd-Frank after the Great Recession, the LCR rule requires enough cash or easy-to-sell assets to cover one month of liabilities.
- “Advanced Approaches” Rule: Established before the financial crisis, these rules outline how to calculate a bank’s capital position.
During the Q&A portion of Powell’s FOMC press conference last week, Greg Robb of MarketWatch asked about Powell’s confidence in the stability of the financial system given the lack of FSOC oversight of nonbanks. Powell acknowledged the potential risks in the nonbank sector and noted that, “another Lehman Brothers [could] come up out of the ground… which could be capable of creating systemic risk.”
Despite this admission, Powell said that FSOC authority over systemically important nonbank financial firms should be used “sparingly.” Powell’s remarks were disappointingly consistent with the deregulatory agenda of the administration and out of line with the goals of Dodd-Frank — the $50 billion threshold was chosen for a reason and that was not for designation to be used sparingly.
While its monetary policy agenda seems to be on track, the Fed is quietly pursuing a “tailoring” agenda, helping big banks shed some of the regulatory burden of Dodd-Frank. Whether or not these changes will precipitate another crisis is yet to be seen, but the Fed should fully consider their implications on systemic risk and financial stability.