BPInsights: March 25, 2023

What Went Wrong at SVB?

The Silicon Valley Bank failure has ignited discussion of what went wrong and how bank policy could change. While we still have more to learn about what led to the collapse, a recent BPI Q&A offers a preliminary look at SVB’s problems and the potential policy implications.

Five Key Things

1. Yellen Draws Line on Deposits, Says U.S. Ready to Take Action if Needed

Treasury Secretary Janet Yellen said this week that the federal government could use its emergency tools to take further action to stem any contagion in the banking system. “We have used important tools to act quickly to prevent contagion. And they are tools we could use again,” Yellen said in testimony before a House Appropriations subcommittee. “The strong actions we have taken ensure that Americans’ deposits are safe. Certainly, we would be prepared to take additional actions if warranted.”

• Off the table: Insuring all bank deposits is “not something that we’re considering,” Yellen said at a separate Congressional hearing this week. Yellen was responding to Sen. Bill Hagerty (R-TN), who expressed concern about reports that Treasury was weighing the use of the Exchange Stabilization Fund to backstop universal deposit insurance coverage. “Such a program would not only constitute a misuse of the ESF, but it would circumvent Congress’s role in approving such an action,” Hagerty said. Yellen clarified that invoking the systemic risk exception in a bank failure permits the FDIC to protect all depositors, and that “would be a case-by-case determination,” but said “I have not considered or discussed anything having to do with blanket insurance or guarantees of all deposits.” Hagerty told Yellen that Congressional approval in a joint resolution is required to expand deposit insurance coverage broadly beyond the $250,000 limit.
• Earlier this week: Yellen on Tuesday emphasized that the government’s post-SVB actions were aimed at preventing contagion rather than targeting specific banks or types of banks. “The steps we took were not focused on aiding specific banks or classes of banks,” she said in a speech at an American Bankers Association conference. “Our intervention was necessary to protect the broader U.S. banking system. And similar actions could be warranted if smaller institutions suffer deposit runs that pose the risk of contagion.”

2. Key Takeaways from Powell’s Press Conference

Federal Reserve Chair Jerome Powell held his regular post-FOMC-meeting press conference this week. The FOMC voted to raise the target fed funds rate by 25 basis points. Powell’s comments shed new light on the Fed’s thinking amid the SVB fallout.

• Confidence: The banking system is strong and resilient, and the Fed, Treasury and FDIC’s recent actions in the wake of SVB’s failure “demonstrate that all depositor savings and the banking system are safe,” Powell said. He added that the central bank’s new Bank Term Funding Program and the discount window are meeting the “unusual funding needs that some banks have faced.” He also said, when asked about potential deposit insurance expansion, that “you’ve seen that we have the tools to protect depositors when there’s a threat of serious harm to the economy or to—or to the financial system, and we’re prepared to use those tools. And I think depositors should assume that their … deposits are safe.”
• What went wrong: Powell reiterated that the Fed is undertaking an internal review of regulation and supervision of Silicon Valley Bank and said it would be “inappropriate” at this stage to offer his views. “At a basic level, Silicon Valley Bank management failed badly,” Powell said, noting the bank’s rapid growth and significant liquidity risk and interest-rate risk exposure. He described the bank as an outlier. He expressed “100 percent certainty that there will be independent investigations” of the SVB situation and said he welcomed it. When asked if the Fed’s Board knew about San Francisco examiners’ escalating actions, Powell replied: “I’ll have to come back to you on that. I don’t know.”
• The decision: Powell explained that the FOMC considered pausing interest rate rises, but ultimately decided against it, supported by “very strong consensus.” The credit tightening that could arise from recent banking system events would “work in the same direction as rate tightening” and could be thought of as the “equivalent of a rate hike or perhaps more than that.”
• Digital bank run: Powell suggested that the digital speed of the SVB run deserved consideration in any regulatory or supervisory changes. “It’s very different from what we’ve seen in the past,” he said. “And it does kind of suggest that there’s a need for possible regulatory and supervisory changes, just because supervision and regulation need to keep up with what’s happening in the world.”
• Lending facility: Powell said Section 13(3) of the Federal Reserve Act gave the central bank “a little more flexibility” to stand up its new lending program. “It seemed to be the right place,” Powell said.

3. Lawmakers Seek SVB Answers

Lawmakers from both parties are eyeing Silicon Valley Bank, its former executives and its supervisors for answers on its collapse.

• Testimony: Senate Banking Committee leaders Sherrod Brown (D-OH) and Tim Scott (R-SC) urged the former chief executives of SVB and Signature Bank to testify before the Committee. Both former CEOs had declined to testify at the panel’s hearing on March 28, according to the senators’ letter.
• Oversight: Ranking Member Scott and House Financial Services Committee Chair Patrick McHenry (R-NC) directed the Federal Reserve to preserve records related to SVB and Signature. The lawmakers requested a detailed timeline of events related to the Fed’s lending, supervisory and examination activities with SVB and Signature over the last two years; a timeline supporting the recommendation to invoke the systemic risk exception for the banks; and the names and titles of Fed staffers involved with such activities. Senate Banking Committee Republicans also sought answers in a letter to the Fed and the San Francisco Fed. A letter from Rep. Bill Huizenga (R-MI), Young Kim (R-CA) and Andy Barr (R-KY) also questioned Vice Chair for Supervision Michael Barr and San Francisco Fed chief Mary Daly on SVB supervisory issues. 
• FDIC auction: Letters from Chair McHenry and Rep. French Hill (R-AR) this week sought information from the Treasury Department and FDIC on their responses to the bank failures, including “whether there was a viable private sector option for Silicon Valley Bank and Signature Bank.” Sen. Bill Hagerty (R-TN) separately called on the FDIC’s Inspector General to probe the agency’s initial failed auction of SVB. Hagerty suggested that “FDIC directors or employees may have intentionally frustrated available methods of resolving SVB that both are required by law and would have resulted in lower costs to the taxpayer.” Treasury Secretary Janet Yellen responded at a recent hearing to a question from Sen. Mike Crapo (R-ID) on whether the FDIC “slow-walked” finding a buyer. “I know that the FDIC looked for buyers and a merger acquisition is certainly something that they were open to as a way to resolve the institution,” Yellen said. It is still possible that the FDIC could find a buyer, and the FDIC could have invoked the systemic risk exception earlier in the process to enable a loss-sharing arrangement that would have supported an SVB sale and reduced disruption and cost.

4. BPI’s Heather Hogsett Testifies Before House Subcommittee on Cybersecurity, CISA’s Contributions

Heather Hogsett, senior vice president, technology and risk strategy for BITS — the technology policy division of the Bank Policy Institute — testified this week before the U.S. House Subcommittee on Cybersecurity and Infrastructure Protection. The testimony examines the state of cybersecurity in the United States and how the Cybersecurity and Infrastructure Security Agency plays an important role in protecting U.S. cyberspace. It also offers recommendations to further CISA’s objectives and improve the collaboration already underway.

• What BPI is saying: “There have been notable improvements since CISA’s formation in faster declassification and sharing of threat information, including a significant increase in publications, alerts and joint advisories with other government agencies,” stated Hogsett. “We encourage CISA to continue to invest in these efforts while prioritizing cross-sector coordination and fully implementing the Cyber Incident Reporting for Critical Infrastructure Act with consideration given to harmonizing existing regulations.”
• Learn more here.

5. Crypto Risks Flagged in Fed’s Custodia Denial Order

The Federal Reserve this week published its order denying Wyoming crypto firm Custodia’s application for Fed membership. Here are some notable takeaways from the order: 

• Run risk: The Fed’s concerns about Custodia’s proposal to cater to a niche clientele and accept only uninsured deposits may seem particularly relevant in light of the SVB turmoil. “In general, the Board has heightened concerns about banks with business plans focused on a narrow sector of the economy,” the order says. “Those concerns are further elevated with respect to Custodia because it is an uninsured depository institution seeking to focus almost exclusively on offering products and services related to the crypto-asset sector, which presents heightened illicit finance and safety and soundness risks.” The Fed described Custodia’s setup as “an unprecedented business model that presents heightened risks involving activities that no state member bank previously has been approved to conduct.”
• Worst-case scenario: In yet another excerpt highly topical in the SVB context, the Fed expressed doubts that Custodia could be resolved safely and effectively if it failed. 
• Revenue streams: Custodia’s financial viability would depend on doing business through activities that would not be permitted by the Fed, the order says. “Without the ability to conduct these crypto-asset-related activities, the financial condition, including the future earnings prospects of the institution, is uncertain,” it says.
• Big picture: The central bank flagged “significant deficiencies” in Custodia’s risk management and controls related to its core banking products and services, including with respect anti-money laundering requirements of the BSA and requirements relating to OFAC sanctions; IT; internal audit; financial projections; and liquidity risk management practices, and further found that those deficiencies “negatively reflect on Custodia’s ultimate capacity to offer novel crypto-asset-related products in a safe and sound manner, especially given the heightened risks associated with those products.”

In Case You Missed It

FinCEN Must Preserve Beneficial Ownership Data Usefulness, Discourage Inappropriate Reporting Omissions

BPI submitted comments to the Financial Crimes Enforcement Network this week expressing concern about the proposed reporting form for its beneficial ownership final rule. The proposal would allow reporting companies to omit information as “unknown” or “unable to identify” without requiring them to clarify why the information could not be provided.

• What BPI is saying: “Consistent with the Corporate Transparency Act, the usefulness, accuracy and completeness of the beneficial ownership information reported to FinCEN should be paramount,” wrote BPI in its letter. “Therefore, we urge FinCEN to adjust the form to require a reporting company, each time it checks an ‘unknown’ box, to explain why it was unable, and the efforts it undertook, to obtain the required information. This will ensure that the reported information is accurate and complete, and the usefulness of the information reported to FinCEN to all authorized users is not limited.”
• Check out BPI’s full recommendations here.

BoE Warned U.S. Regulators Over SVB Risks, Bailey Says

The Bank of England warned U.S. authorities, including the San Francisco Fed, about the risks building up at Silicon Valley Bank ahead of its failure, according to a letter from Governor Andrew Bailey reported by the Financial Times. The U.K.’s Prudential Regulation Authority scrutinized the concentration of SVB’s client base, according to the FT. The BoE had concerns about such concentration risk and overlap of clients between SVB’s lending and deposits “18 to 24 months preceding its seizure by US regulators on March 10,” the article says.

Who’s One of the Biggest Winners in the SVB Failure?(Oh Circle)

Stablecoin firm Circle was one of the biggest beneficiaries of the recent U.S. government backstop for Silicon Valley Bank depositors, according to the Financial Times’ Alphaville blog. Circle held $3 billion of its reserves at SVB and its USDC stablecoin broke its dollar peg amid the bank’s failure. Its secondary-market price rebounded back to a dollar only after depositor protection for SVB was announced, according to the FT. Despite the stablecoin’s rocky course, Circle CEO Jeremy Allaire tweeted this week about the firm operating “with the highest level of transparency in this industry” and being “held to high standards.” He also gave a recent speech decrying “the limitations of this fractional reserve banking system.”

Fed Releases 2022 Annual Financial Statement 

On Friday afternoon, the Federal Reserve released its audited annual financial statement for 2022. 

• The Fed reported that it lost $15.4 billion in the fourth quarter and earned $58.8 billion for the year. 
• The Fed reported that it had remitted $59.4 billion to Treasury for the year even though it had remitted $73.4 billion to Treasury for the first nine months of the year.
• The reduction in remittances was not because the Treasury paid the Fed back some funds in the fourth quarter.  Instead, the Fed increased its deferred asset by $14.4 trillion, an amount that it also passed through net income.  The deferred asset equals the future earnings the Fed must make and keep before it resumes remittances to Treasury.
• At the end of the year, the Fed had $1.1 trillion in unrealized losses on the securities in its portfolio, down slightly from the losses at the end of the third quarter.  The Fed had $673 billion in unrealized losses on its holdings of Treasury securities and $408 billion on its holdings of agency MBS.

The Crypto Ledger

The SEC this week announced that it charged several celebrities, including actor Lindsay Lohan, with illegal promotion of crypto assets. Here’s what else is new in crypto.

• White House report: The sweeping Economic Report of the President compares the claims of crypto benefits to the reality of the crypto ecosystem – and draws several critical conclusions. Some argue that crypto assets may provide benefits such as improving payment systems or increasing financial inclusion, the report says. “So far, crypto assets have brought none of these benefits. Meanwhile, the costs generated by several of their aspects—such as those for consumers, the physical environment, and the financial system—are not only substantial but are also being accrued in the present.” Downside risks of crypto assets include their speculative nature, the run risk of stablecoins, fraud and scams and crypto’s use in illicit finance and ransomware, according to the report. It also previews the launch of the Fed’s FedNow payment service, scheduled in July, and describes the potential benefits and risks of a U.S. CBDC.
• Do Kwon charged: U.S. prosecutors charged Do Kwon, the co-founder behind the collapsed TerraUSD stablecoin, with fraud. Kwon’s stint as an international fugitive ended this week with an arrest in Montenegro.
• Coinbase on notice: The SEC warned Coinbase in a Wells notice that it had identified potential securities law violations. Potential actions could relate to the crypto firm’s spot market, staking service Coinbase Earn, Coinbase Prime and Coinbase Wallet, according to a Coinbase regulatory filing cited by CNBC.

Who’s First in Line? Credit Suisse AT1 Bonds Ignite Debate

Controversy ensued after Swiss regulators decided to impose losses on the holders of Credit Suisse’s AT1 (additional tier 1) bonds.  As the FT reports it, AT1s are a class of debt designed to take losses when institutions run into trouble but are generally believed to rank ahead of equity on the balance sheet. This didn’t happen in the CS situation, where Swiss authorities forced a total write-down of $17.4 billion in CS’s AT1 before orchestrating the sale of the remaining equity in CS to UBS for $3.5 billion, along with government guarantees and a bespoke liquidity lifeline from the Swiss National Bank.  The decision, with legal circumstances specific to the Swiss jurisdiction, will likely trigger lawsuits from bondholders. Meanwhile, UK and EU authorities moved swiftly to differentiate AT1 bonds issued by UK/EU banks, saying the Swiss outcome on AT1s couldn’t be replicated under the UK/EU rules. 

Banking Outlook, Global Business: Q&A with Citi’s Jane Fraser

Citigroup CEO Jane Fraser discussed a wide range of topics this week in an Economic Club of Washington, D.C. Q&A. She expressed optimism about the banking sector outlook, described the broad reach of Citi’s global operations and discussed the challenges of taking the bank’s helm during COVID.