With Comments In, Fed Considering Changes to ‘Well Managed’ Qualifications

The Federal Reserve Board of Governors (the Fed) is weighing changes to its ratings approach for assessing large financial institutions’ safety and soundness. If it adopts the proposed guidelines, banks will no longer need satisfactory ratings in all three of the components comprising the review framework to receive the Fed’s coveted “well managed” rating. 

This summer the Fed published a proposal to revise its Large Financial Institution Rating System (LFI) and Framework for the Supervision of Insurance Organizations. In it, the Fed suggests cutting to two the number of satisfactory ratings components required of organizations with over $100 billion ($50 billion for foreign banks in the U.S.) in assets to earn the Fed’s sterling certification.  

Currently, an institution must achieve a satisfactory rating in all three areas of the Fed’s assessment pillars to achieve “well managed” status: 1) capital planning and positions; 2) liquidity risk management and positions; and 3) governance and controls. 

The comment period for the proposal, which includes a provision allowing banks to still qualify as ‘well managed’ with one Deficient-1 rating, ended August 14. A wide range of industry groups, academics, public interest groups, and former regulators commented on the proposal.  

“I think you’re seeing a major paradigm shift between administrations and a view that maybe [supervisory bodies] went a little too far in management and control factors that drive ratings and didn’t emphasize financial risk enough,” said Richard Rosenthal, principal at Deloitte & Touche LLP.  

As of last year, more large banks were falling short of the coveted “well managed” designation than weren’t, with two-thirds of outstanding matters related to firms’ governance and controls, according to the Federal Reserve’s semiannual report on supervision and regulation covering the first half of 2024. 

Operational resilience, cybersecurity, and Bank Secrecy Act and Anti-Money Laundering compliance were among the areas where the Fed found issues, it said. “The challenge is that the steps for remediating and resolving the issues could require multi-year programs, with unclear criteria, to be considered a successful remediation and closure to the regulator’s concerns,” says Irena Gecas-McCarthy, principal at Deloitte and director of the Deloitte Center for Regulatory Strategy.  

Given this high rate of Deficient ratings in the governance and controls regulatory rating pillar, many in the industry have come to consider the approach to governance and controls under LFI “too subjective,” Rosenthal said. The Fed’s proposal, though, has not suggested changing the criteria for how these areas will be assessed. 

The Elusive “Well Managed” Rating 

While the Fed affirmed in its 2024 report the soundness and resiliency of the banking system overall, it showed less-than-satisfactory ratings on two-thirds of banks for the first half of 2024, roughly in line with the same period in 2023. Banks that didn’t achieve “well managed” represented about $17 trillion in assets. 

Most banks did, though, meet supervisory expectations with respect to capital planning and liquidity. Still, the Fed cited continued weakness in risk-management practices for interest rate and liquidity risk—factors contributing to the failures of a few banks in 2023. 

This latest proposal to change LFI isn’t the first time the Fed has considered the rating system’s supervisory fit, and it likely won’t be the last. In a 2020 speech, then-Vice Chair for Supervision Randal Quarles said the Fed would need to carefully monitor the “ascetic principle” of the lowest rating determining a bank’s “well managed” status, “no matter how good [it] is at everything else.” In this proposal, the Fed has indicated that “other changes to the frameworks and existing supervisory ratings systems will be considered in the future.” 

In casting the lone vote (6-1) against the proposal this summer, Fed Governor Michael Barr, appointed under President Biden, argued that the change would effectively allow “firms that are not well managed to be treated as though they were.” 

He said such firms "would be allowed to undertake activities that only healthy firms should undertake, which increases risk to individual banks, consumers, and the financial system.” 

For Barr, the proposal “removes the presumption that firms will take action to remediate significant deficiencies” and would decrease “firms’ incentives and urgency to remediate shortcomings.” 

The stakes for achieving a “well managed” rating can be high. Potential enforcement actions aside, failing to achieve it can have far-reaching repercussions on bank strategy and a firm’s financial flexibility. The Bank Holding Company Act, among other things, permits a firm that is “well managed” to “engage in certain expansionary activities and to pursue investments in and acquisitions of certain non-bank financial companies without obtaining prior Board approval.” 

“If you aren’t ‘well managed,’ regulators can deploy a number of tools in their toolkit including applying asset growth restrictions, considering enforcement actions, and requesting remediation plans under specific timetables,” Gecas-McCarthy said. The ability for ‘well managed’ bank holding companies to benefit from expedited Fed payments processing, governed under Regulation Y, and to carry out other mergers and acquisitions might also be affected.   

The industry has consistently lobbied to adapt the LFI assessment criteria to reflect the realities of each institution’s size, asset mix, and risks. The Fed’s approach references these same elements.  Early on, the Fed and the industry coalesced around the idea of “tailoring” reviews to acknowledge that not all banks above a certain size operate the same way. 

“The approach since 2019 has been to try to tailor supervision using asset and other thresholds,” while staying consistent in assessment techniques,” Gecas-McCarthy said. “The question is the consistency in examinations conducted and what institutions were putting in place to adjust to those category thresholds.” 

With new Vice Chair for Supervision Michelle Bowman at the helm, “subjectivity” is now a Fed focus.  Bowman has outlined an agenda to overhaul supervision, advocating for a more transparent and prescriptive process. This proposal aims to re-weight financial factors in the assessment and lighten the burden of solving non-financial issues for achieving the top ranking. 

Removing the stick? 

Rosenthal believes banks will remain motivated to fix deficiencies, even if the Fed removes “the stick” from its LFI enforcement toolkit. “Will some banks just go, go, go and grow? Probably. But many will try to find the balance between managing risk and growing substantively,” he said. 

Gecas-McCarthy and Rosenthal say that regardless of the proposal’s outcome, firms that are introspective and design a comprehensive set of governance, control, and risk practices that scale with their business model will stand the best chance of being prepared. “It pays banks to build a sustainable risk and control framework resistant to changes in administration and agnostic to the pendulum swings of regulations,” Rosenthal said. 

That includes investing in talent, infrastructure, and processes and tracking emerging risks that come with developments like AI and digital assets to ensure the firm stays ahead of and can manage the changing landscape. The challenge, too, is keeping up, as risks turn into realities faster than they ever have. “We’re moving much faster,” he said. “You’ve got to keep investing and maintaining vigilance to stay on top of these risks.”    

Added Gecas-McCarthy: “We advise clients to play the long game and align to what makes sense for their strategy, business/operating model, and their risk profile.”