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Don't rush to undo the 'tailoring' of bank liquidity requirements

Christopher M. Russo
American Banker
Published February 9, 2024 (930 words)

The collapse of Silicon Valley Bank on March 10, 2023, ranks among the largest bank failures in U.S. history. Approaching the one-year anniversary of its collapse, agency officials are signaling a proposal to tighten bank liquidity requirements. The effort is spearheaded by Michael Barr, whom President Biden nominated as the Federal Reserve's vice chairman for supervision in 2022. While not yet public, the proposal will likely undo the tailoring of liquidity requirements under the prior administration. President Biden blamed tailoring, in part, for SVB's collapse.

"Tailoring" refers to the regulatory reforms following the bipartisan Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018 (S. 2155). In relevant part, Title IV of S. 2155 raised the threshold for mandatory application of "enhanced prudential standards" (i.e., the strictest capital, liquidity and stress testing requirements) from $50 billion to $250 billion. Regulators could still "apply any prudential standard" to banks above $100 billion, but application must be based on its capital structure, riskiness, complexity, financial activities, size and other risk-related factors. That is, S. 2155 ended the one-size-fits-all regulatory approach to midsize banks like SVB.

As then-nominee Barr testified before the U.S. Senate Banking Committee, "reasonable people can disagree" over the merits of S. 2155's tailoring of regulatory requirements for midsize banks. I saw this disagreement firsthand while serving as the committee's Republican staff economist, a role in which I vetted Mr. Barr during his confirmation process. While Mr. Barr noted that he "would have chosen a different balance" for tailoring, he acknowledged that S. 2155 had "garnered widespread support" in Congress and committed "to implementing the law as written."

As a "key architect" of the Dodd-Frank Act, it is unsurprising for Vice Chairman Barr to revisit tailoring. Nonetheless, I am concerned that he will rush this consequential rulemaking ahead of the 2024 election. Unless this rule and others are finalized at least 60 legislative days prior to the seating of the new Congress, Republicans could sweep to power and overturn them under the Congressional Review Act. In 2017, Republicans did so fourteen times to Obama-era rules. While a rushed rulemaking may be politically expedient, rushing begets sloppiness. In turn, sloppy rulemaking raises the chance of substantive and procedural weaknesses that undermine the rule. I see three potential problems.

First, Barr might argue that tighter liquidity requirements would have prevented the collapse of SVB. However, the claim that tailoring caused the collapse of SVB is not supported by the publicly available evidence. In a 2023 study from the U.S. Congress Joint Economic Committee, I found that SVB would have needed a 200% liquidity coverage ratio (LCR) to withstand its deposit outflows, which is double the 100% LCR requirement imposed on the largest banks. I estimated that meeting a 100% LCR requirement would have reduced SVB's illiquidity risk by less than 1%.

Rather than rely on a partisan narrative about SVB, Vice Chairman for Supervision Barr should ensure the rulemaking is justified by careful cost-benefit analysis. That would require showing that the economic benefits (e.g., reductions to illiquidity risk) outweigh the economic costs (e.g., lower economic growth). Unfortunately, the agencies' recent track record has been poor. Last year's proposal to tighten capital requirements did not include a cost-benefit analysis. While the banking agencies do not have an organic statutory requirement for cost-benefit analysis, Supreme Court precedent and executive branch policy recognize the importance of cost-benefit analysis for good rulemaking.

Second, Barr might fail to promptly disclose the data required to evaluate the rulemaking. For example, if Vice Chairman Barr disputes my study's finding that liquidity tailoring did not cause the failure of SVB, then the agencies should disclose any data used for their own statistical analysis (e.g., nonpublic data on SVB's financials). While the Administrative Procedure Act requires a public comment period, the public cannot substantively comment on rules based on secret data.

Here, the agencies' recent track record is also concerning. Last year's capital proposal was based on stale data. The Federal Reserve appears to have recognized the issue: During the comment period, it launched a new data collection effort. However, it did not make this data available before it ended the comment period, limiting the ability of the public to substantively comment.

Third, Barr might fail to align the liquidity proposal with the requirements of S. 2155, as he committed to doing under oath. Again, recent experience raises concerns. The capital proposal seems to violate the plain language of the law by subjecting midsize banks to the same requirements as the largest banks without regard to their capital structure, riskiness, complexity, size, etc. Crucially, the APA authorizes courts to set aside rules "not in accordance with law." While agencies typically rely on the Chevron defense in such cases, Chevron may soon be overturned.

Keep in mind, rulemaking is not an all-or-nothing proposition. Barr can limit the rulemaking to only those changes that meet the economic cost-benefit test and are aligned with the law. The vice chairman can also reduce risk by keeping Federal Reserve supervisors focused on safety, soundness and financial performance. Moreover, Barr can support reforming the Federal Reserve's monetary policy framework to promote financial stability, such as by adopting rules-based policy.

Ultimately, I gently caution Barr and other agency principals to ignore the political calendar. If you rush, then these weaknesses could prompt litigation that sinks the entire endeavor. Instead, focus on getting the cost-benefit analysis right and following the law. No matter the electoral result, you would be better positioned to convince a bipartisan group of lawmakers to support your changes, just as such a group supported tailoring.