The Federal Reserve Board has completed the most substantial revision of its supervisory rating system for large bank holding firms, the most significant revision since 2018. The revisions will radically transform the way leading financial firms rate “well-managed” to engage in their line of business, possibly impacting their operational capacities, mergers, or acquisitions. The revision is also aimed at capturing the overall health of the bank without holding banks with isolated inadequacies against other components.
How the new rating framework transforms bank evaluations
The supervisory rating process used by the Fed focuses on three core areas of the large banks, which are capital, liquidity, and controls. The three areas are awarded one of four possible ratings, categorized from “broadly meets expectations” to “deficient-2.” Under the new system, banks with one “deficient-1” are allowed to be “well-managed,” which marks a big relaxation of the previous criteria.
The overhaul corrects the rigidity long criticized about the former system being too inflexible. Under the old system, banks received “not well-managed” ratings even if banks had strong performance on two out of three areas, having stricter operational challenges than seemed necessary in many quarters. The American Bankers Association & Bank Policy Institute made the current overhaul necessary, stating banks were represented by isolated problems, not their entire management practices.
Vice Chair Bowman emphasizes a holistic assessment approach
The importance of the new approach of the framework was explained by the Vice Chair for Supervision, Michelle Bowman, in her explanation of why the modifications are necessary. The revamp of the system is designed to focus on the entire evaluation instead of the components, allowing the net condition of the firm to be the central element that will be taken into account in the ratings, having in mind that sound banks sometimes face challenges in particular areas.
What these developments mean for banks across the country
Those banks categorized as “not well managed” are facing operational constraints, which may include limitations on some operational activities, apart from the possibility of acquiring other banks. The softened framework will decrease the chances of banks being categorized as “not well managed” even if those banks are experiencing isolated operational problems but are otherwise sound.
The reforms also help bring the big bank ratings system into greater line with the supervisory approaches designed for other banking firms. The reform will also enable banks to focus their attention on problematic areas that are system-wide instead of having them worry about the excessive impacts of problems in one component area.
Key Framework Changes:
- “Well Managed” with a rating of one deficient 1
- “Not well managed” if there is any deficiency, 2 rating
- Improved consistency with other supervisory evaluation systems
- Implementation period of 60 days from the date of publication in the Federal Register
What this regulatory shift means for banking supervision
What is particularly transformative about these changes to the rating system is not the specifics of the modifications, but the underlying shift in the Fed’s perspective from one that believed banks with sound structures would be destabilized by challenges inherent in particular components to one that accepts banks with strong structures will be resilient even if there are challenges with some of their components without undermining safety and soundness.
The overhaul of the rating system by the Fed is, in itself, the turning point in the banking supervision world in the US, with the system taking into account the reality that even the soundest financial firms may occasionally face problems with particular aspects without impairing their core stability. The system, in effect, indicates the increasing maturity of bank supervisors, who can conclude that banks are “well-managed” even if there are some shortcomings in isolated areas, without impairing their core stability.