Federal Reserve Vice Chair for Supervision Michelle Bowman offered a pointed observation last week: some of the most consequential shifts in financial policy are not the product of deliberate votes or formal rule changes. Instead, they emerge quietly, when regulations written for one set of conditions become more and more binding as the conditions evolve.
Bowman’s remarks centered on the need to regularly reevaluate the regulatory framework governing the banking sector. Her core argument is that regulations imposed as prudent guardrails may become inadvertent roadblocks if left unexamined. When this happens, the regulations risk distorting financial behavior and undermining the broader objectives of monetary and financial stability. In short, outdated regulation can become de facto policy, with unintended (and often undesirable) consequences.
Bowman said financial regulation “should not be created in a static world of ‘set it and forget it.’” A rule that was well-designed in a previous era may no longer be effective under current conditions. Indeed, it may even be counterproductive. She pointed to several forces that might cause such a shift:
- major shifts in monetary policy;
- rapid technological change within the banking sector; and
- the expansion of financial intermediation outside traditional banks.
Consider the Supplementary Leverage Ratio (SLR). The SLR ensures banks maintain a minimum level of capital relative to their total assets, regardless of how risky the assets they hold are. It was originally intended as a backstop to risk-weighted capital requirements. In recent years, however, macroeconomic developments—most notably, the growth of central bank reserves and heightened liquidity—have transformed the SLR into the binding constraint for some of the largest banks. This was never the rule’s intended function. As Bowman noted, such a shift is not a minor technical glitch. It constitutes a new policy regime that warrants explicit attention and reconsideration.
The practical consequences are significant. Under the SLR, banks are discouraged from holding safe, low-risk assets such as Treasury securities. Since both Treasury securities and riskier assets raise capital requirements when the SLR is binding, but riskier assets have a higher expected return, banks have an incentive to hold the riskier assets. The problem is especially severe when bank balance sheets are expanding, as they did when deposit inflows picked up during the pandemic, since the SLR “increases the amount of required capital as bank balance sheets grow, regardless of the underlying risk.”
For Bowman, the SLR example illustrates the case for dynamic financial supervision, an approach that continually reassesses the relevance, effectiveness, and unintended effects of regulation. Rather than “set it and forget it,” she calls for a supervisory culture that embraces regular recalibration in light of evolving financial realities.
Bowman’s call for “smart” regulation is appealing. But one should not expect all regulatory adjustments to be improvements. If poorly executed, a dynamic framework might just as easily introduce new distortions or instabilities. Regulators might benefit from more frequent rule reviews, as Bowman claims. But they should also develop a greater appreciation of successful market-based, self-regulatory mechanisms, which often adapt more quickly and flexibly than formal rules imposed by the government.
