Fed Governor Identifies Seven Risks for Bank Regulators

Federal Reserve Board Governor Michael S. Barr warned of seven specific near- or long-term risks for bank regulation and supervision.

In a speech at the Georgetown University Law Center marking the end of his tenure as Vice Chair for Supervision, (see prior coverage), Mr. Barr highlighted the following risks ahead for the banking sector:

1. Post-Financial Crisis Reforms. Mr. Barr emphasized the importance of completing post-financial crisis reforms, particularly implementing Basel III reforms. (See related coverage.) Mr. Barr said he supports requiring large banks to hold long-term debt to aid in orderly resolutions during crises. He said banks should stay vigilant to known risks in the commercial real estate market and those involving interest rates.
2. Stress Testing. On the Fed's announced intention to propose disclosing and seeking public comment on all stress test models, (see related coverage), he acknowledged the need for transparency, but raised several concerns. He warned that: (i) banks may use transparency to challenge aspects of the Fed's models that increase capital requirements while ignoring areas where the models underestimate risk; (ii) increased disclosure could enable banks to adjust their balance sheets to optimize stress test results without meaningfully reducing risk; (iii) transparency may discourage banks from investing in their own risk management, lead to asset concentration in areas that receive lighter stress test treatment and reduce management buffers; and (iv) "dynamism and accuracy" of stress tests will fade given the difficulty of navigating the notice and comment rulemaking process on an ongoing basis to update the models.
3. Supervision. Mr. Barr highlighted the value of proactive supervisory engagement, which allows banks to resolve issues early with minimal impact on profitability.
4. Innovation. Mr. Barr advocated for "responsible" innovation, particularly as to blockchain technology and crypto-assets.
5. Cyber. Mr. Barr urged banks and the Fed to invest in cyber resiliency. He warned that (i) operational failures at single IT entities can have far-reaching effects due to the concentration in the industry and (ii) advances in AI are likely to give bad actors new tools for fraud.
6. The Nonbank Sector. Mr. Barr highlighted growing risks concerning hedge funds, private credit and the insurance industry. He said that bank exposures to hedge funds have increased, with leverage remaining near historic highs. He warned about the Treasury cash-futures basis trade, where high leverage could exacerbate market stress. In addition, he said that private credit has also expanded rapidly, reaching a size comparable to the high-yield bond market and emphasized the need for continued monitoring and regulatory measures to mitigate these evolving financial sector vulnerabilities.
7. Climate Change. Mr. Barr urged regulators to continue to confront the financial risks from climate change. He argued that the recent wildfires in California should be a "wake-up call" to focus on how insurance markets must adjust to frequent and severe weather events.