Federal Reserve Board Clarifies and Amplifies Supervisory Operating Principles

The Federal Reserve quietly released an updated Statement of Supervisory Operating Principles last Friday. The principles build on reforms under the Vice Chair Bowman from last year, but largely refine—and in some cases amplify—them, particularly concerning supervisory criticisms and enforcement actions. They come shortly after Randall Guynn became Director of the Division of Supervision and Regulation. They reflect immediate changes that can be implemented outside of the administrative law process that applies to substantive regulations as opposed to interpretive guidance.

On balance, they favor Fed-supervised institutions both procedurally and substantively. A redline of the principles is available here. 

Key Takeaways

• The Fed has provided more detail about when Matters Requiring Attention (MRAs), Matters Requiring Immediate Attention (MRIAs), and enforcement actions are appropriate: For enforcement actions based on unsafe and unsound practices, the principles use a substantially higher standard requiring an abnormally high probability of abnormal harm. The principles still look to a risk or evidence of material financial harm generally.
• Remediation is encouraged and rewarded: Self-identified violations or deficiencies that would otherwise meet the standard for MRAs, MRIAs, or enforcement actions are presumptively treated as (mere) supervisory observations. Supervisory staff is also directed ordinarily to rely on a banking organization's internal audit validation to determine whether issues have been fully remediated.
• General fairness: Supervisory staff is expected to communicate deficiencies clearly and act fairly and in good faith. Fed-supervised banking organizations are expressly encouraged to report noncompliance to the highest levels.

What Changed

• The primary objectives of supervision are stated clearly: While not a substantive change, the principles clearly frame the objective of the Fed's activities in supervision:
  
  • To identify as early as possible:
    
    • significant threats to the safety and soundness of a Fed-supervised banking organization and to U.S. financial stability and
    • any violation of law or regulation.
  • To encourage or direct each Fed-supervised banking organization to take timely proportionate action to eliminate or mitigate those threats and violations as promptly as possible.

Thus, the focus is both identification and resolution of issues, rather than supervisory activity that catalogs and preserves—detached from the prospect of prompt, effective, and final remediation—any and all issues. The changes that follow all flow from this focused articulation of the Fed's objectives.

• MRAs and MRIAs: The principles expand on last year's general directive that MRAs and MRIAs should "[p]rioritize deficiencies that could have a material impact on a firm's financial condition, rather than focusing on procedural or documentation shortcomings that do not materially threaten the firm's safety and soundness." That standard has been retained in substance, but with more attention and detail:
  • Good faith: To issue MRAs and MRIAs, supervisory staff must determine in "good faith"—that is, with sufficient evidence—that a particular estimate of probability and severity is plausible and a deficiency exists that, if not remediated in a timely manner, would create a significant probability of significant harm to the financial condition of the banking organization or has resulted in significant actual harm to the financial condition of the banking organization.

    That change in language implies that some previous supervisory ratings/criticisms may have been issued in less-than-good faith, which, if accurate, is a remarkable admission and change. It likely reflects a critique and prohibition of prospective, preemptive use of MRAs and MRIAs on safety and soundness grounds as a catch-all category.

  • No material differences in communication: There shouldn't be any material differences between the supervisory criticisms communicated in the final exit meeting for an examination and those contained in the written examination report.
• A new abnormal-squared standard for enforcement actions: To issue enforcement actions, a new, higher standard is required. Staff must determine that an act or failure to act would, if not remediated in a timely manner, create an "abnormal probability of abnormal harm to the financial condition of the banking organization." The Fed clarifies that "abnormal" means substantially higher than normal or significant. That is quite a high standard that meets or exceeds what many in industry, such as the Bank Policy Institute, have consistently argued for, and the Horne standard, which informed the Financial Institutions Supervisory Act of 1966 and served as a fundamental benchmark to keep supervision in check.
• Modifications: A clear reference to the Vice Chair for Supervision's (or delegate's) ability to modify the severity and probability standards, as permitted by law, is included. This appears to be a reservation of authority to be used in expedient situations.
• Development of new quantitative tests: The Fed announced in the principles that it is developing various quantitative tests to determine whether a realized or unrealized loss would constitute significant harm to the financial condition of a Fed-supervised banking organization as a matter of supervisory policy. It previewed two tests that would establish "significant harm"—these are where the estimated loss would cause (or has caused) the banking organization to:
  • be less than well capitalized as determined on a historical cost or fair-value basis or
  • suffer an outflow of a significant amount of cash or other liquid assets within a short period of time.

It is possible the Fed will update these principles or supplement them once those tests are finalized. The development of quantitative tests should allow for less subjective and inconsistent standards applied across banking organizations and regions.

• Accountability for supervisory staff: A Fed-supervised banking organization not just may, but is encouraged, to report a failure to comply with any of the principles by directly contacting the Head of Supervision of its relevant Reserve Bank or the Fed's Deputy Director for Supervision. We note that while a more robust and effective supervisory appeals process is still needed, this appears to be a good-faith effort to provide relief where appropriate within the context of supervision.

• Remediation: The principles clearly provide a pathway for remediation that mitigates violations or deficiencies, and leads to finality. This is consistent with the stated primary objectives and the substantive principles, which in each case say that actions or failure to act, if not remediated in a timely manner, may lead to MRAs, MRIAs, and enforcement actions based on a threat to safety and soundness.
  • Self-identification and a presumption of more favorable treatment: If a Fed-supervised banking organization self-identifies a deficiency that would otherwise satisfy the standard for an MRA or MRIA based on a threat to safety and soundness and promptly starts remediating that deficiency in a manner determined to be reasonable by supervisory staff, the deficiency will presumptively be treated as giving rise to a supervisory observation, rather than an MRA or MRIA.

  • Relying on internal audit's validation: In addition, supervisory staff generally is expected to assess a banking organization's internal audit validation, and if it is satisfactory, rely on it. Cases where the Fed would not rely on internal audit's validation include where the internal audit function is ineffective or unsatisfactory, lacking/nonexistent, or where internal audit has not validated the remediation. In such cases, the supervisory staff may perform its own validation. Absent those factors, supervisory staff may not perform such "duplicative validations."

    Prompt termination: As in the 2025 principles, the Fed still expects staff to "change the way they decide whether an MRA, MRIA or requirement in an enforcement action can be terminated because the underlying deficiency has been fully remediated," and expects supervisory staff not to delay termination. The new principles expect prompt termination ("as promptly as possible") after remediation. If there has not been adequate remediation, then new MRA or MRIAs or more forceful action are expected. This would appear both to help banking organizations get out of the penalty box as well as avoid the piling up on unresolved MRAs—as seen in the 2023 bank failures.

• Other examinations: While reliance on other agencies' examinations has been retained (as required by statute), the principles have softened in favor of the supervisory staff on this one point. The Fed may conduct its own examination of depository institution subsidiaries when it is "not reasonably possible" for the Fed to rely on the examination by the primary state or federal regulator. Last year's principles only allowed an independent exam if it was "impossible" to rely on another examination. But a duplicative examination is still not permitted simply because the Fed might conduct it differently.
• Early resolution encouraged: The principles note that supervisory staff should facilitate the early resolution of troubled insured depository institutions to minimize the long-term cost to the Deposit Insurance Fund as contemplated by law. Taken together with other principles, this may signal a move toward winding down these types of institutions rather than subjecting them to a long process of growing and unresolved MRAs over a long period of time.

What Didn't Change

The principles still retain much from last year's approach, including that supervisory staff should:

• Follow the new approach and not assume prior (more restrictive and opaque) approaches apply.
• Focus on material financial risks, not processes, procedures, and documentation that do not pose a material risk to safety and soundness (the check-the-box exercises that have been previously criticized).
• Give equal weight to the management and risk management components of CAMELS and other RFI/C (D) ratings. The Vice Chair Bowman has previously announced that the Fed is considering changes to the regulation that underpins supervisory ratings.

Our Take

The 2026 principles are a further and welcome development of the Fed's reforms for supervision following its public admissions of inadequacy following the 2023 bank failures, as well as the last administration's full-court-press approach to any and all violations using both supervision and enforcement aggressively. The Fed continues the pivot from a cop-on-the-beat approach to a focus on material financial risks that takes into account the private sector's efforts to remediate and better understand shifting expectations and changing risks.

These reforms are expected to place firmly in the rear view mirror the days when the Fed could drive excessively burdensome settlements from banking organizations by the mere threat of a finding of an unsafe and unsound practice in connection with what may have been process errors or minimally harmful oversights. It restores "safety and soundness" to its original meaning which is not now, and never should have been, measured by a standard of perfection.

The revised principles, in our view, are more befitting a sophisticated agency working with sophisticated market participants.

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Max Bonici and Steve Gannon are partners in DWT's Washington, D.C. office. For questions or more insights, please reach out to the authors or another member of our financial services team and sign up for our alerts.