by Oscar Valdés Viera, Senior Policy Analyst, Private Equity & Capital Markets
The Federal Reserve recently weakened the rating system it uses to supervise the country’s largest banks, making it easier for banks to pursue riskier investments that could imperil the financial system. These ratings help determine whether giant financial institutions are considered “well managed.” Banks that keep that label can pursue acquisitions, take on more risks, and expand into a broader range of activities.
The Fed’s new rule makes it easier for large banks to keep that favorable status even when regulators have identified serious deficiencies in capital, liquidity, or governance. In effect, it inflates the “well managed” grade for the biggest and most systemically important banks in the country in a way that weakens oversight, dilutes accountability, and leaves the banking system more vulnerable.
The Large Financial Institution framework worked
The Large Financial Institution, or LFI, framework applies to bank holding companies and certain large savings and loan holding companies with at least $100 billion in assets. It evaluates whether banks are strong and well run enough to remain safe and sound through a range of stressful conditions. It does so by looking at three key areas: capital, liquidity, and governance and controls. In other words, it examines whether a bank has adequate financial cushions to absorb losses under stress, enough liquid resources to meet demands in a panic or run, and appropriate internal discipline to identify and manage risks before they spiral out of control.
The framework was instituted as a result of the lessons of the 2008 financial crisis. After the crash, policymakers strengthened bank oversight because they learned that weak supervision, poor risk management, and inadequate safeguards at large financial institutions threaten not only the bank’s viability but also the stability of the broader U.S. financial system and the whole economy. Stronger capital rules, liquidity standards, stress testing, and supervisory scrutiny helped make the system more resilient. The LFI framework was part of that broader effort to make sure the largest banks were not only profitable in good times, but capable of operating safely under stress too. These guardrails helped keep the financial system on an even footing even during the economic stress of the pandemic and the 2023 banking crisis.
A dangerous rollback threatens financial stability
The Fed’s new revisions move in the opposite direction. Under the prior approach, if a large bank received a deficient rating in any of the three main categories, it would not be treated as “well managed.” A bank with serious shortcomings in capital, liquidity, or governance was directed to fix those problems before being allowed to expand or engage in mergers and acquisitions.
The new rule changes that. Now a big bank can still be considered “well managed” even if it has major deficiencies in capital, liquidity, or governance. The rule also removes the earlier presumption that banks with deficiencies would face restrictions until they were corrected.
That is a dangerous rollback. A deficient rating is not a minor supervisory finding. It means that regulators have found financial or operational weaknesses significant enough to threaten a firm’s safety and soundness under a range of conditions. Those weaknesses can extend well beyond balance sheet issues. A bank could be struggling not only with capital or liquidity, but also with serious failures in risk management in areas such as internal audit, cybersecurity, anti-money laundering, or consumer protection compliance. Yet under the new framework, a large bank can sweep those kinds of problems under the rug and still keep the label that signals it is well run.
Giving shaky banks a license to gamble
Firms with the “well managed” status can move more quickly on expansionary activities, receive streamlined regulatory treatment, and more easily pursue investments in and acquisitions of nonbank financial companies. Lowering the standard for who qualifies could accelerate consolidation and allow already enormous institutions to become even larger and more complex, worsening the too-big-to-fail problem that post-crisis reforms like the LFI framework were supposed to address.
Supervisory ratings are meant to be prophylactic and identify problems before they become crises and to push firms to fix dangerous weaknesses before they spiral out into the broader financial system. If regulators start handing out passing grades to firms with serious deficiencies, the ratings lose credibility and usefulness. They stop operating as a meaningful check and start serving as a rubber stamp for banks to pursue risky strategies even though they should be under tougher scrutiny.
The Silicon Valley Bank (SVB) example shows why this is so alarming. Under the previous LFI framework, SVB lost its “well managed” status in 2022 after the Federal Reserve downgraded its governance and controls rating because its risk management practices fell below supervisory expectations. Critics have noted that under the new revised framework, SVB could have retained the “well managed” status until the day it failed in March 2023 because its other component ratings remained satisfactory.
The economic risks of banking deregulation
The lesson from the 2023 failure of SVB is that if big banks have serious financial or operational deficiencies, the answer is not to loosen the definition of “well managed.” It is to require the bank to correct those problems before it grows, expands, or takes on more risk.
The costs of big bank failure are not isolated to the balance sheets of lenders and investors. The interconnectedness of banks, financial firms, and the broader economy mean that stresses in the banking system can become contagions that threaten the financial system. Workers, families, small businesses, and communities often end up paying when badly managed banks stumble and regulators act too late. These financial crises can create deeper and longer economic downturns. The whole point of strong supervision is to reduce the odds that private mismanagement becomes a public problem and that the public purse is once again used to bailout stumbling large banks.