Federal Reserve reviewing confidential ratings for US big banks, WSJ reports

The Federal Reserve is conducting a comprehensive review of its confidential internal rating system used to evaluate the largest U.S. banks, according to reliable sources familiar with the matter. This assessment could potentially lead to significant changes in how major financial institutions are supervised.

Examination of the Rating Framework

The central bank’s internal review focuses on the Large Financial Institution (LFI) rating system, a confidential assessment framework implemented in 2019 that evaluates major banks across three critical categories: capital planning, liquidity risk management, and governance.

Under this system, banks receive ratings ranging from “Broadly Meets Expectations” to “Deficient-1” and the most severe “Deficient-2.” Financial institutions rated in the deficient categories face restrictions on their growth and expansion activities until they address the identified weaknesses.

Sources indicate that the review was initiated earlier this year and is being led by senior officials within the Federal Reserve’s supervision department. The examination aims to determine whether the current framework effectively identifies risks and promotes appropriate responses from financial institutions.

Industry Context and Potential Implications

The review comes at a sensitive time for the banking industry, following significant turbulence in 2023 that saw the collapse of several regional banks, including Silicon Valley Bank and First Republic Bank. These failures prompted heightened scrutiny of regulatory oversight and risk management practices across the sector.

Banking executives have privately expressed concerns about the rating system’s implementation, particularly regarding consistency in how different regulators apply the framework. Some have suggested that the ratings process has become increasingly stringent, with higher expectations for compliance and risk management.

Any modifications to the rating system could have substantial implications for affected banks, potentially influencing their strategic decisions, compliance costs, and ability to pursue mergers or expansions.

Regulatory Background and Context

The LFI rating system applies to domestic banks with assets exceeding $100 billion and to U.S. operations of certain foreign banking organizations. It represents a modernized approach compared to the previous CAMELS rating system, which evaluates banks on capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk.

Unlike the CAMELS ratings, which are applied to smaller banks and assign numerical scores, the LFI system uses qualitative assessments focused on forward-looking risk management rather than point-in-time conditions.

The Federal Reserve has not publicly commented on the existence or scope of the review. A spokesperson for the central bank declined to provide specific details when contacted, stating only that the agency “continuously assesses its supervisory approaches to ensure they remain effective and appropriate.”

Industry Response and Expert Perspectives

Banking industry representatives have generally welcomed the review, suggesting it provides an opportunity to address perceived inconsistencies in the current system.

Financial regulation experts note that the timing of the review is significant, coming as the banking sector prepares for potential regulatory changes under the incoming presidential administration, which has signaled interest in revisiting certain financial regulations.

“Any revision to how major banks are evaluated could have far-reaching consequences for financial stability and market competitiveness,” noted one regulatory policy expert who requested anonymity due to the sensitivity of the matter. “The challenge is balancing effective oversight with operational flexibility for institutions.”

Timeline and Next Steps

According to sources familiar with the process, the internal review is expected to continue for several months, with potential recommendations for changes emerging in 2025. Any significant modifications to the rating system would likely involve consultation with other banking regulators and potentially a public comment period.

Banking analysts suggest that institutions are closely monitoring developments, as changes to the rating framework could influence strategic planning, compliance investments, and risk appetite decisions.

The outcome of this review may also provide insights into the Federal Reserve’s broader supervisory priorities under its current leadership and how these might evolve in response to changing economic conditions and emerging financial risks.

Financial sector observers note that the assessment comes amid growing attention to the challenges of effectively supervising increasingly complex financial institutions in a rapidly evolving digital landscape, where traditional risk boundaries are increasingly blurred.