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From Banking and Finance Law Daily, March 4, 2015

Yellen queries bank culture, discusses evolution of large-firm supervision

By Richard A. Roth, J.D.

In the aftermath of the financial crisis, the Federal Reserve Board and other federal regulators have emphasized more effective supervision of the largest financial institutions due to their importance to financial stability, according to Fed Chair Janet Yellen. She described how the Fed’s supervisory efforts have improved and the benefits those improvements have had in remarks prepared for the Citizens Budget Commission. The Fed chair also took the opportunity to question bank management ethics.

“[W]e expect the firms we oversee to follow the law and to operate in an ethical manner,” Yellen said, calling the need to make the point “unfortunate.” Bankers at large institutions have sometimes “brazenly” failed in this duty. Their actions “raise legitimate questions of whether there may be pervasive shortcomings in the values of large firms,” according to the Fed chair.

Regulatory changes. Yellen noted five regulatory changes that have helped the Fed improve its supervision:

  1. higher capital standards, especially for the largest financial institutions;

  2. higher liquidity requirements for the largest institutions;

  3. stress tests;

  4. the orderly resolution authority and living wills; and

  5. the Fed’s greater financial stability authority, such as its authority to impose enhanced prudential standards on the most important institutions and its cooperation with other supervisors through the Financial Stability Oversight Council.

Capital. Yellen emphasized the importance of higher capital standards, noting that stress tests and the annual Comprehensive Capital Analysis and Review help the Fed analyze whether financial institutions hold enough capital not just to survive stressful conditions but to continue to meet customers’ needs. If the Fed is not satisfied with a firm’s capital position, it now has the ability to prevent the firm from taking actions that would reduce its capital, such as paying dividends or buying back shares.

Fed improvements. “[T]he Federal Reserve is requiring more of large institutions. We are also requiring more of ourselves,” Yellen said. In particular, she described how the Large Institution Supervision Coordinating Committee brings together staff members from across the Fed to contribute their views on supervisory issues. This helps the LISCC look at financial stability risks “from the broader economy, financial markets, and other sources.”

Results. As a result of this enhanced supervision, the largest institutions’ capital and liquidity positions both have improved since the financial crisis, according to Yellen. The capital held by the largest institutions has doubled since 2009. These firms’ high-quality liquid assets have increased by one third, and they now rely considerably less on short-term, wholesale funding that is seen as less reliable.

Risk management, internal controls, and corporate governance have improved, but not enough, in Yellen’s opinion. More improvement is needed, and “supervisors will be watching closely,” she warned. Many of the living wills submitted so far also have “a number of shortcomings,” according to the Fed chair.

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