Fed Proposes to Eliminate Reputation Risk from Supervisory Programs
Commentary by Thomas Delaney
The Federal Reserve Board of Governors ("FRB") proposed a rule to codify the removal of reputation risk from its supervisory programs.
The FRB stated that the revisions were necessary to "increase supervisory clarity" and address concerns that reputation risk and similar supervisory tools "have been misused." The agency said that a recent Executive Order raised concerns regarding debanking, and that reputation risk can be "difficult to quantify and communicate, making it challenging for firms to remedy identified concerns." The FRB argued that codifying this removal would facilitate greater precision in decision-making and support the FRB's supervisory focus on "core financial risks."
The FRB explained that the proposed rulemaking would establish a binding regulation to ensure that the actions of supervisory staff are "not based on reputation risk" and align with broader policy. The new rule would explicitly prohibit the FRB from encouraging or compelling supervised entities to "deny or condition the provision of banking or other financial products or services" to an individual or business based on their "constitutionally protected political or religious beliefs, associations, speech, or conduct." It would also prohibit such action based on an individual’s or a business’s involvement in "politically disfavored but lawful business activities."
The FRB highlighted the following reforms in the proposal (i) defining "reputation risk" as the potential that negative publicity will cause a decline in the customer base, costly litigation, or revenue reductions; (ii) affirming that the decision to make a loan, open or close an account, or modify terms "rests with the banking organization, acting in accordance with applicable law;" (iii) permitting continued criticism and supervisory feedback to address other objective risk channels related to safety and soundness, such as credit, market, liquidity, and operational risk; and (iv) preserving the FRB's authority to implement and enforce applicable statutes, noting that enforcement of laws like the Bank Secrecy Act and OFAC sanctions programs "would not be restricted."
Comments on the proposal must be received on or before 60 days after its publication in the Federal Register.
Commentary
The rule that the Federal Reserve Board proposed yesterday will ban Board supervisory staff from rating bank lending practices on whether a bank’s credit decisions may give rise to reputational risk. This proposal aligns with the Administration’s broader supervisory objective to depoliticize credit (and other bank product) decisions, which was announced last year with the release of Executive Order 14331 that targeted "debanking" based on a borrower’s political affiliation, religious beliefs or otherwise lawful business activities.
In explaining the need for Monday’s proposal, the Board noted that, "[o]ver time, concerns have arisen that reputation risk and other similar supervisory tools have been misused." Thus, the proposal is intended to ensure that actions and decisions of supervisory staff are not based on reputation risk and instead are intended to return the Board’s supervisory focus to core financial risks facing the banking sector. The Board noted that safety and soundness concerns that motivated it to include reputation risk as a supervisory consideration are adequately addressed through other existing risk types, such as credit risk, market risk, liquidity risk, operational risk and legal risk.
While barring reputational concerns from being factored directly into the supervisory process, the proposal appears to acknowledge that protecting a bank’s reputational standing remains an appropriate consideration for senior bank management. In this regard, the proposal emphasizes that it "is not intended to impact the ability of banking organizations to manage their businesses and make independent decisions regarding their customers. The decision regarding whether or not to make a loan or to open, close, or maintain an account, provide any other financial product or service, or modify the terms of any financial product or service rests with the banking organization, acting in accordance with applicable law." Presumably this acknowledgement is intended to reassure bank senior management that within the bounds of laws such as the Equal Credit Opportunity Act and the Fair Housing Act, the proposed rule preserves management’s ability to consider reputational risk when making credit decisions, that could expose the bank to class action litigation, shareholder revolt, or other reputationally, damaging events.