Banking regulators claim that they are not loosening regulation and supervision but rather shifting the focus from box-checking processes to “material financial risk.” They have been largely successful in promoting this narrative. But does this view stand up to scrutiny? Can they even define material financial risk?
Defining Material Financial Risk – Or Not
On May 19, 2026, banking regulators sent out a request for comment regarding proposed changes to the CAMELS rating system. CAMELS are essentially the report cards that regulators give banks, and adverse ratings can lead to restrictions on activities. The request for comment uses the phrase “material financial risk” 38 times without ever bothering to define the term.
A proposal to define “‘unsafe or unsound practice” and to revise standards for matters requiring attention (MRAs) and CAMELS downgrades discusses material financial risk in terms of likely financial harm. The proposal defines neither “likely” nor “material.” It did solicit comments on whether to provide quantitative thresholds for “likely” and “material” and what those thresholds should be. This inability to provide a clear definition suggests that “material financial risk” may be what Professor Shane Littrell calls “corporate BS” or wording that “superficially and misleadingly seems more impressive, important, and informative than it actually is.” Moreover, requiring that a risk “likely” results in material harm reflect a fundamental misunderstanding of the nature of risk. After all, Russian roulette has only a 17% chance of resulting in harm but is still a terrible idea.
The “material financial risk” mantra is a relatively new one among regulators. A search of the Federal Reserve’s website references “material financial risk” 51 times. All but three were written in 2025 or 2026. The only exceptions were exam reports related to Silicon Valley Bank. The FDIC included 14 references, with ten coming from 2025 and 2026. The four exceptions included two from the Vice-Chair Hill, quoting the Bank Policy Institute and the other two were comment letters related to climate risk. None of these references were very precise on what “material financial risk” really means in practice.
Despite the vagueness of the term, bank regulators have been quite successful in sanewashing some extreme changes to bank supervision. AI models are, by their nature, reflective of current discourse. For example, when asked whether banking regulators are placing more emphasis on material financial risks, ChatGPT answered with a resounding “yes” that contrasted this focus with the former approach that supposedly emphasized “values-oriented oversight frameworks (such as climate-specific guidance or ‘reputational risk’ supervision).” ChatGPT went on to note “That does not mean regulators are becoming less concerned about risk overall. In many respects, supervision is intensifying — but around risks viewed as directly threatening systemic stability or bank solvency.” But does this credulous take have any basis in reality?
Where is the Evidence?
While much of bank supervision operates outside the public eye, we can look at indicators of whether bank supervision is intensifying or lightening up. Two publicly available indicators are formal enforcement actions and trends in CAMELS ratings.
Enforcement Actions. Presumably, less emphasis on processes should be more than made up by more emphasis on material financial risks. OCC has issued 11 formal enforcement actions and terminated 36 since February 2025. That total contrasts with 39 formal enforcement actions and eight terminations between January 2024 and January 2025. The contrast is even more extreme if we incorporate the typical lag between a regulatory finding and a formal enforcement action. From July 2025 on, OCC has issued only three formal enforcement actions while terminating 32. While some cyclicality to enforcement actions is common, the extreme movement suggests a decidedly lighter touch to supervision.
CAMELS Ratings. Okay, maybe supervision isn’t intensifying, but was previous supervision overly harsh? Consider the distribution of CAMELS ratings. OCC’s 2025 Annual Report shows that 93% of national banks received a CAMELS rating of 1 or 2 in FY2025. The last time this figure fell below 90% was in 2014. It’s hard to view a rating system as overly harsh if more than 90% receive the top two grades.
I Know it When I See It?
Justice Potter Stewart once wrote that while he might struggle to define pornography, he knew it when he saw it. The same can be true of material financial risk. While it may be unclear exactly what banking regulators have in mind when it comes to material financial risks, decades of experience can give us some idea of what financial risks are most material. Let’s look at some recent regulatory initiatives in the context of material financial risk.
Capital and leverage. For financial institutions, the most fundamental element of risk is capital and its converse, leverage. Capital can serve as a shock absorber that cushions against the ups and downs of the business cycle. Leverage amplifies risk. As we saw in the 1980s, insufficient capital requirements can also encourage excessive risk taking. Banks are more willing to pull the goalie if they have little to lose. Are capital requirements getting tighter? Quite the opposite. Actions on the Basel Endgame, the supplemental leverage ratio, the community bank leverage ratio, and capital stress testing all represent a significant loosening.
Leverage Lending. Risky lending is also a material financial risk. Leverage lending involves loans to highly indebted companies, usually with high debt to income ratios and low credit ratings. Guidance issued in 2013 did not disallow this activity but required banks to establish limit frameworks, ensure adequate loss allowances, identify underwriting authorities, and provide adequate reporting to the board of directors. Regulators rescinded this guidance in 2025, claiming the guidance was “overly restrictive.” Moreover, it supposedly “resulted in a significant drop in leveraged lending market share by regulated banks.” They did not, however, provide any rationale for why federally insured banks need to preserve market share in a risky lending area.
New charters and new activities. Between 2008 and 2010, more than 27% of all bank failures involved institutions less than ten years old at the time of failure. We saw a similar pattern with savings and loan charters during the 1980s. Banking regulators have made chartering new banks a priority, with a particular focus on novel charters. Since 2025, OCC had approved 16 new charters with an addition 42 applications in the pipeline. Fourteen pending applications involving institutions “planning to offer digital asset products or services, including crypto-assets.”
Entry into new and unfamiliar areas has been a surefire way for a bank to get into trouble. Construction loans, subprime loans, complex CMOs and CDOs, structured advances. The list goes on and on. That doesn’t mean that banks must always stick with the familiar and eschew all risk. It does mean they should move with caution. In the name of “innovation” regulators are pushing banks into new activities, ready or not. For example, OCC’s October 2025 Semiannual Risk Perspective include a special section on “innovation,” declaring that a lack of innovation may present a material risk. OCC prominently mentions AI and digital assets as examples. Massive campaign spending by the AI and crypto firms couldn’t have anything to do with it, could it?
Model risk management. At first glance, model risk management may appear to be more closely related to processes than to actual financial risk. But in the 21st Century, the best way to measure financial risk is through models. The collapse of CMO and CDO structures played a major role in the Global Financial Crisis. Rating agencies initially rated these securities as AAA because they assumed tail risk followed a normal distribution and that correlations between assets was stable. Both the conclusions and the underlying assumptions proved to be disastrously wrong.
A 2026 revision to model risk management guidance didn’t exactly repudiate earlier, more detailed guidance. It did, however, substitute vague principles for specifics and largely cut bank examiners out of the process. When it comes to quantifying risk, we’ll pretty much have to take the banks’ word for it.
Preventive supervision
Effective banking regulation depends on preventive supervision. Spotting warning signs and excessive risk taking early allows supervisors to intervene when the bank is still salvageable. That means taking prompt action and focusing on leading rather than lagging indicators of problems.
Taking prompt action. Supervisors at the Federal Reserve did a decent job in identify liquidity concerns at Silicon Valley Bank. They did a terrible job in taking supervisory action with any sense of urgency. The Fed’s post-mortem attributed this inaction in large part to supervisory policythat “placed a greater emphasis on reducing burden on firms, increasing the burden of proof on supervisors, and ensuring that supervisory actions provided firms with appropriate due process.” The emphasis on burden reduction, burden of proof, and “due process” for bank is even greater today.
The Federal Reserve recently laid out supervisory operating principles. While providing lip service to “focusing it on identifying and taking timely proportionate action as early as possible” the specifics of the new process tell quite a different story. The policy limits MRAs to deficiencies that create a significant probability of significant harm to the financial condition” of the bank or “actual harm.” Enforcement actions would require examiners to estimate the “probability and severity of a particular deficiency to the financial condition” on the bank. Really? A good examiner could see that SVB was an accident waiting to happen two years ahead of its failure. The same goes for banks that loaded up on subprime mortgages ahead of the GFC. But providing a probability? Please.
Another example is the appeals process for supervisory actions. FDIC recently changed and OCC is proposing changes to the process to make it more favorable to appealing banks. The rationale for these changes rests largely on representations by unreliable narrators rather than any hard evidence. Examiners do make mistakes, but the appeals run in only one direction. No one will appeal a rating as too favorable. In FY 2007, 96% of national banks were rated 1 or 2. The banking system was already showing signs of strain and required a massive rescue the next year. If the proposed appeals process were in place, the 96% figure could only go higher.
Leading versus lagging indicators. We have decades of experience identifying the leading and lagging indicators of financial trouble. One of the best leading indicators is the quality of bank management. Leaving aside any issue of personal dishonesty, banks that get into trouble are usually characterized by aggressive managements that prioritize growth and short-term profitability over risk management and controls. Meanwhile, regulators are now trying to place less emphasis on the quality of management and the quality of risk management.
Making likely and material financial harm a prerequisite for taking supervisory action ignores evidence that bank failures are usually a few years in the making. The chart below shows trends in both the number of bank failures and the total assets of failed banks. Declining mortgage underwriting standards became most pronounced in 2005 and 2006. But there were zero bank failures either year. Bank failures ticked up in 2007 and soared in 2008. At that point nonconforming mortgage lending had already disappeared. We saw a similar pattern in the 2020s. The number of bank failures has remained low throughout the decade, but the assets of failed banks in 2023 set a record. There were no failures the prior two years, but that’s when the risk taking occurred.
Some Concluding Thoughts
There can be a legitimate debate over the relative emphasis on quantitative vs. qualitative factors. A good case can be made to place greater emphasis on regulatory bright lines. There are also some quantitative leading indicators. These include rapid growth, concentrations, higher risk assets, and interest rate exposure. But that’s not what we’re seeing today. In some of the cases noted above, regulators are not just weakening qualitative standards, but quantitative standards as well.
There can also be a case for lighter touch supervision. Advocates for the new approach could claim that the potential benefits in terms of lower compliance costs and economic growth are worth the risk of a few additional bank failures. I don’t find the argument especially persuasive considering our experience over the past 45 years. But at least it would be honest.
Leave a Reply