Fed’s exam ratings system needs upgrade, Quarles says

WASHINGTON — Federal Reserve Vice Chairman for Supervision Randal Quarles on Friday called for an overhaul of bank supervisory ratings, arguing that more transparency about the process of scoring an institutions safety and soundness would make the Fed’s oversight more effective.

“There is broad agreement that ratings are a beneficial, even necessary, part of bank supervision,” he said at a virtual event held jointly by the Fed, Harvard University and the University of Pennsylvania. “Yet we have very few studies or other empirical support for this conclusion.”

Like the other federal bank regulators, the Fed uses a confidential ratings system known as Camels to assign a combined safety and soundness score to a bank as well as ratings for five performance areas: capital adequacy, assets, management capability, earnings, liquidity and sensitivity to market risk.

The Fed scores most bank holding companies through its so-called RFI system, which stands for risk management, financial condition and impact, but larger bank parents are subject to the “large financial institution” ratings system introduced in 2018.

“Even if we were to make no changes to our ratings frameworks, going through the process of assessing this calibration will surely provide a valuable learning experience,” said Fed Vice Chair of Supervision Randal Quarles.

Bloomberg News

Quarles said that the Fed could do more to make its ratings frameworks “reliably consistent and predictable for all banks.”

“Banks could benefit because they would be better positioned to anticipate supervisory feedback and understand what steps they need to take to improve their ratings,” he said. “Supervisors can benefit by being grounded in more predictable criteria.”

Quarles said he has specifically directed Fed staff to look into the qualitative elements of the Fed’s ratings frameworks, whether the Fed could be more clear about how it weights the qualitative and quantitative factors in its ratings, and the overall effectiveness of the Fed’s new LFI ratings.

“Even if we were to make no changes to our ratings frameworks, going through the process of assessing this calibration will surely provide a valuable learning experience,” Quarles said. “It would also increase our conviction in the legitimacy of our ratings frameworks and our confidence as a prudential supervisor.”

Quarles also said he wants to do a deep dive into how bank ratings vary by examiner. He suggested that ratings could be affected by the specific point time that an exam has been conducted, and that a better approach may be to apply “the scrutiny of multiple parties with a range of perspectives and experiences” instead of a single examiner.

He also proposed that the Fed look into whether examiners should have to review banks’ compliance with certain regulations, like the Fed’s liquidity risk management standards, and factor such evaluations into a rating.

The Fed should also urge examiners and economists to conduct more empirical analysis around supervisory ratings, Quarles said.

“As supervisors, we should be extremely supportive of efforts to better understand ratings as an assessment and communication tool, as well as those [efforts] that make our supervision processes have more repeatable outcomes,” he said.

Federal Deposit Insurance Corp. Chair Jelena McWilliams spoke at the same event Friday, and described her agency’s approach to supervision as a “collaboration.”

“Simply put, institutions should not be surprised by findings in examination reports, because open communication over time with their supervisory agency should notify them of potential issues in advance,” she said.

McWilliams also noted that the FDIC has continued to explore ways to modernize its supervision, and is looking to leverage technology to shorten the amount of time examiners spend on-site at banks and speed up examination turnarounds.

“Obviously, we’re not going to fundamentally transform the industry and the FDIC during the remainder of my tenure as chairman, but we’re going to tackle these challenges with urgency, and we’re going to lay the foundation for the future of banking,” she said.

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