BPInsights: May 13, 2023 - Bank Policy Institute

A Failure of (Self-) Examination

A thorough review of SVB’s exam reports yields conclusions very different from those in the Fed’s self-assessment.

The Federal Reserve recently released a report on its oversight of Silicon Valley Bank that was conducted by Vice Chair for Supervision Michael Barr. One of the report’s key takeaways was that regulatory tailoring and a shift in supervisory policy impeded effective oversight of the bank, an assertion supported with scant evidence and contradicted by the actual underlying examination materials for SVB.

A different story: Those exam materials tell a very different story, namely that:

Fed examiners were principally focused on SVB’s nonfinancial risks and regulatory compliance matters, and not the fundamental weaknesses in SVB’s risk profile that led to its failure.
To the extent that examiners did identify and convey concerns in the areas that directly contributed to SVB’s failure, examiners were far too focused on risk management processes and procedures, and not on actual risk.
While examiners issued numerous MRAs and MRIAs based on general supervisory expectations, they failed to enforce several key regulatory requirements, including those in Regulation YY that required SVB to have a CRO and to hold a sufficient liquidity buffer as per its internal liquidity stress test results.
The rapid shift in SVB’s supervisory ratings and the Fed’s acknowledgment that lower ratings may have been warranted suggest that those ratings frameworks are highly subjective, lack clear standards, and are not focused on actual risks and financial condition.

Bottom line: The underlying examination materials released alongside the Fed’s report contradict the narrative that the tailoring law deprived supervisors of the tools they needed to oversee SVB and that the supervisory culture at the Fed had become lax. The materials depict an examiner culture of vigorous engagement, but not on the most pressing, important issues. Overall, a picture emerges of multiple supervisory failures driven by an approach that was principally directed at issues that had little to do with SVB’s core safety and soundness concerns, a consistent focus on process over substance, a failure to apply rules already on the books, and a reliance on supervisory ratings that depended on subjective judgments and not objective data. Somewhat oddly, the report touches on such issues by flagging better identification of risk by supervisors as a potential area for further Fed study, and suggesting that the SVB failure “suggests an opportunity to shift the culture of supervision toward a greater focus on inherent risk.” But these observations do not appear in the report’s key takeaways. They clearly deserve more urgent attention.

Five Key Things

1. Death by Delays: Why the Bank M&A Process is Broken

The termination of TD Bank’s proposed acquisition of First Horizon illustrates flaws in the bank merger review process that ultimately make the banking system less healthy, former OCC officials Keith Noreika and Bryan Hubbard wrote in a recent American Banker op-ed. The “hostile environment” for bank M&A “has a real chilling effect on activity that would otherwise allow weaker banks to combine with stronger ones,” they wrote. “Instead of harvesting fruit when ripe, it rots on the vine because uncertainty and a lack of decision-making transparency leave market participants reluctant to act because delays are costly, and boards and shareholders hate uncertainty.”

Timely and transparent: “The market needs a system it can rely on for timely, transparent decisions based on facts and the economic sense of the individual deals, not politics or incumbent protection,” Noreika and Hubbard wrote. “When applications for mergers and acquisitions pose an actual threat to the safety and soundness of the system, to competition or to the convenience and needs of consumers, regulators should act in a timely manner to disapprove such proposals. When proposals meet criteria for approval, regulators should act on their independent authority to approve them.”
Elsewhere in M&A: A more general Bloomberg article, focused on the DOJ and FTC, highlights how U.S. antitrust overseers have chilled M&A in several industries. In the 12 months through September, the antitrust agencies filed complaints against a record 13 transactions compared to an average of six per year over the last five years, the article says. In a telling excerpt, the article alludes to deals withdrawn before seeing the light of day: “The agencies are also claiming credit for another 26 mergers that they say were abandoned in the face of antitrust investigations, some of which were pulled before they were even made public.”

2. Tailoring, China, Debt Limit: JPMorgan’s Dimon on What’s Happening in Washington

JPMorgan CEO Jamie Dimon recently spoke with Punchbowl News in an interview published in the Vault newsletter this week. In the interview, Dimon weighed in on several key issues on policymakers’ minds in Washington.

Tailoring and SVB: Tailoring regulations did not cause SVB’s failure, Dimon said in the interview. “We don’t believe that the problem was caused by that change in regulation that happened a couple of years ago,” he said. Overly stringent requirements could harm smaller banks, Dimon suggested. “If you overdo certain rules, requirements, regulations — there are some of these community banks that tell me they have more compliance people than loan officers,” he said in a separate Bloomberg TV interview this week. Dimon has repeatedly emphasized the necessity of regional banks, as well as large and small banks, for the economy. He noted in the Bloomberg interview that regional banks are “quite strong” despite recent upheaval.
Debt limit: Dimon emphasized the need to avoid panic around the debt limit and that a U.S. default would pose significant risks. “On the default itself, think of it in two pieces: the run-up to a default and an actual default,” he said. “It’s even bad to have the run-up to default because that can question American debt ratings. We’re foundational to the economy of the world.” He added that “I hope one day we get rid of it,” referring to the debt limit.
China: Dimon called for a “tough but thoughtful” approach to China and a recognition that the U.S. has many strategic advantages over its chief economic rival.

3. Fed Supervision’s Struggle: Sweating Small Stuff, Not Focusing Enough on Big Issues

Challenges in supervisory culture are nothing new at the Fed, despite language in the central bank’s SVB report that appeared to place blame with the supervisory environment under Michael Barr’s article

Quarles: Former Vice Chair for Supervision Randal Quarles said he directed supervisors to hit hard on major problems instead of focusing on smaller infractions. “I wasn’t able to do much on supervision and it’s evident that I really didn’t get much done on changing the culture, because the objective was to stop distracting both the institutions and ourselves with excessive attention to routine administrative matters and focus on what’s really important – like interest rate and liquidity risk,” he said in the article. “I would often use the phrase, ‘And if they won’t do what’s really important, smite them hip and thigh.'”
Key quote: Quarles also said “My message to the supervisors was that they needed to be focused on stuff that really matters, and that they needed to draw the attention of the institutions to stuff that really matters. No doubt with the best of intentions, they clearly did the exact opposite of that here.”
Stack of red flags: The article notes that the 31 MRAs and MRIAs issued to SVB covered a wide range of issues, including many outside the bank’s fatal-flaw issues, such as third-party vendor management.
Slow shifts? The process of implementing changes in supervisory culture across all the Fed’s Reserve Banks and the Board is “no simple task,” the article said.

4. Former Fed Official Dudley: What the Fed Missed in Its Bank Crisis Confessional

The Federal Reserve fell short of recognizing its failure to flag the risks that rising interest rates would pose for the financial system, former New York Fed President Bill Dudley wrote in a Bloomberg op-ed this week. While the central bank has “mostly done a good job of taking responsibility” for its role in recent banking turmoil, Dudley said, it should explain why its financial stability monitoring system didn’t identify the risks sparked by its monetary policy choices. Acting too late in tightening made the shock to banks’ funding costs and the value of their longer-term investments much larger than it would have been if the Fed had been more proactive, Dudley said. The flood of reserves and deposits from quantitative easing also prompted some banks to buy longer-term securities, he suggested.

Lessons: The FOMC should consider financial stability risks in its monetary policy decisions, Dudley recommended. The Fed chair and FOMC must bear ultimate responsibility for financial stability rather than delegating to the vice chair for supervision, he said. Finally, Fed officials overseeing the economy, financial stability, regulation and supervision should work together, rather than in silos.

5. Fed’s Bowman: Rule Changes Should Be Carefully Considered

Fed Governor Michelle Bowman called in a speech Friday for policymakers to rethink their approaches to bank supervision and regulation in several ways. She said policy responses to recent bank failures will have important implications for the U.S. banking system, including the extent to which bank regulation drives financing from regulated banks into shadow banking.

Supervision: Bowman said some banks have become less responsive to supervisors, which may require a change in the supervisory toolkit. “This may mean taking more formal remediation measures, with definitive timelines, and imposing meaningful consequences for firms that fail to remediate issues in a timely way,” she said. Supervision should also be attuned to evolving risks, such as interest rate risk in a rising-rate environment, she noted. While regulation is critical, it operates with a lag, she said. “This is where supervision can complement regulation to address emerging threats and risks by allowing supervisors to pivot to those fundamental risks that may be most salient based on that bank’s business model and evolving economic conditions.”
Regulation: Regulators should keep in mind the backdrop of stringent capital and liquidity requirements in the banking system when considering new changes, Bowman said. “We should be careful and intentional about any significant changes to the regulatory framework, including imposing new requirements that will materially increase funding costs, like higher capital requirements or the requirement of firms to issue long-term debt,” she said. “Many of the issues related to the recent bank failures have been identified in bank management and supervision. Therefore, a broad-based imposition of new capital requirements on all banks with more than $50 billion in assets would be a far more costly solution than taking the time to specifically identify and address known management and supervisory process issues.”
Lender of last resort: Bowman highlighted the need to review the tools that enable the Fed’s lender of last resort function “to determine whether they have kept up with the pace of change for the future payments landscape and expectations of liquidity planning.”
Next steps: Bowman suggested several steps policymakers should take in the wake of the failures: soliciting an independent third-party report on SVB’s failure covering a broader range of topics than the Fed’s internal review; ensuring examiners prioritize core risks and move quickly to address them; and considering whether there are necessary and targeted changes needed in banking regulation. “This will likely include a broad range of topics, including taking a close look at deposit insurance reform, the treatment of uninsured deposits, and a reconsideration of current deposit insurance limits,” Bowman said. “We should avoid using these bank failures as a pretext to push for other, unrelated changes to banking regulation.”
Bottom line: “Even with the implementation of these [tailoring law] changes, banks today are better capitalized, with more liquidity, and are subject to a new range of supervisory tools that did not exist prior to 2008,” Bowman said. “…Calls for radical reform of the bank regulatory framework—as opposed to targeted changes to address identified root causes of banking system stress—are incompatible with the fundamental strength of the banking system. I am extremely concerned about calls for casting aside tiering expectations for less complex institutions, given the clear statutory direction to provide for appropriately calibrated requirements for these banks.”

In Case You Missed It

Bank Short-Selling Draws Prosecutors’ Attention

Short-selling of bank shares in the wake of recent failures has attracted scrutiny from U.S. prosecutors, according to Reuters this week. The activity had also garnered attention from regulators, who are evaluating potential market manipulation, but a focus from Department of Justice criminal prosecutors suggests higher stakes for short sellers.

Biden Nominates Kugler, Jefferson for Fed Board Slots

The White House announced on Friday the nominations of Adriana Kugler to a Federal Reserve Board governor position and Philip Jefferson, a current governor, to be vice chair. The President also announced he will renominate Governor Lisa Cook for an additional term. Kugler, the U.S. executive director to the World Bank, started her career at the San Francisco Fed and later served as chief economist of the Labor Department.

Fed Lending and Recent Turmoil: What’s in the Fed’s Financial Stability Report

The Federal Reserve this week released its regular Financial Stability Report. Here are some key takeaways.

Banking stress: The report included a section on the recent banking turmoil. “For the banking system as a whole, aggregate bank capital levels were ample,” the report said. “At potentially vulnerable banks, examiners have increased the frequency and depth of monitoring, with examination activities directed to assessing the current valuation of investment securities, deposit trends, the diversity of funding sources, and the adequacy of contingency funding plans.” A “large majority of banks are resilient to potential strains from higher interest rates,” the report states.
Near-term risks: The Fed flagged several potential risks in the near term, including: a potential credit crunch arising from recent banking stress; the effects of further rate increases; geopolitical tensions; inflation; and commercial real estate lending.
Funding dynamics: “Funding strains were notable for some banks, but overall funding risks across the banking system were low; meanwhile, structural vulnerabilities persisted in other sectors that engage in liquidity transformation” such as money market funds, the Fed said in the report. That section noted that SVB and Signature Bank were outliers in terms of heavy reliance on uninsured deposits.
Other topics: The report also discussed regular discount window lending (primary credit) and lending under the Bank Term Funding Program, but did not appear to mention Fed lending to bridge banks or to the FDIC as receiver.

Hill Highlights from This Week’s Bank Hearings

The House Financial Services Committee held two subcommittee hearings this week on recent bank failures: an Oversight and Investigations Subcommittee hearing on Thursday on the GAO’s review, and a Financial Institutions and Monetary Policy Subcommittee hearing on Wednesday on federal responses to the failures, featuring industry and policy experts. Here are some key quotes and takeaways from the hearings.

Causes: Oversight Subcommittee Chair Bill Huizenga (R-MI) expressed disagreement with regulators’ diagnosis of the causes of the bank failures. “Unfortunately, as you will hear in testimony today, regulators in Washington are attempting to paint a different picture. But the facts are clear,” Huizenga said at the GAO hearing. “The collapse of SVB and Signature Bank were the result of risky business strategies and years of failed supervisory action.”
Escalation: The San Francisco Fed and the FDIC identified risks at SVB and Signature, but both regulators failed to escalate actions adequately, GAO official Michael Clements said in prepared testimony reflecting the findings of the GAO’s review. Clements reiterated that the two banks used risky business strategies, such as reliance on unstable funding sources, and grew rapidly. The GAO has “longstanding concerns about escalation of supervisory concerns,” Clements said.
Tailoring discretion: The tailoring law, S.2155, gave regulators the discretion to enhance scrutiny on banks, Rep. Dan Meuser (R-PA) said at the GAO hearing. Rep. Andy Barr (R-KY) pointed out at both hearings that SVB was subject to enhanced prudential standards. “Beyond the regulatory framework to which they were subject, the failings were so basic, so fundamental to … risk management 101 as to be glaringly obvious under any regulatory framework,” former OCC official Jonathan Gould said at the Financial Institutions and Monetary Policy Subcommittee hearing. “This attempt to blame regulatory tailoring, or even an insufficiently robust Dodd-Frank regime, is really missing the point here. This was a classic supervisory failure,” Rep. Barr said at that hearing. “It would permanently change the face of the dynamics of banking forever if that happened,” said Keefe, Bruyette & Woods CEO Thomas Michaud at the same hearing, referring to what would happen if tailoring were eliminated.
Capital: Capital was not the core issue in SVB’s failure, Rep. Bill Posey (R-FL) suggested. “Capital is a lagging indicator and the banks that failed were well capitalized upon failure,” Margaret Tahyar, a partner at Davis Polk & Wardwell, said. When asked by Rep. Posey if there were any reasonable capital standard or level that would have protected against the interest rate risk of SVB’s asset base in the period after Fed rate hikes began in March 2022, Jonathan Gould responded “no, it would not.”
Monetary policy: The Michael Barr report “said nothing about the monetary policy errors and the late-to-the-game monetary normalization that contributed mightily to the problem,” Rep. Andy Barr, chair of the Financial Institutions and Monetary Policy Subcommittee, said at that panel’s hearing.
Independent probes: Tahyar called for independent reviews on the bank failures. “There are many good elements in the reports you have before you, but they are drastically incomplete,” Tahyar said. “They are only a first step in any fact-based exercise. There should be a structurally independent investigation by trained professional investigators done on a bipartisan basis.”
Speed of runs: Rep. Blaine Luetkemeyer (R-MO) expressed concern about the speed of the run on SVB and social media’s role in exacerbating it.

ABA, FSF, BPI: Proposed SEC Rule Would Harm Investors, Financial Markets

The SEC’s proposed rule “Safeguarding Advisory Client Assets” would significantly harm investors and financial markets and exceeds the Commission’s regulatory authority, according to a new comment letter filed this week by the American Bankers Association, ABA Securities Association, the Financial Services Forum, and the Bank Policy Institute. The associations urge the Commission to withdraw and resubmit a proposal that is better targeted to the Commission’s objectives.

“The Proposed Rule suggests broad and complex changes that represent a fundamental departure from current industry practice, and, if finalized, would cause significant harm to investors and financial markets,” the groups wrote. “Banks that provide custody services, or ‘custody banks,’ are among the most significant qualified custodians under the current rule, and play a critical, foundational role in the functioning of the global securities markets, ensuring broad operational efficiencies and high levels of investor protection. Custody banks have long offered safe, well-managed, and regulated custody services. The Commission has not identified any significant loss of traditional assets in custody that would warrant an extensive overhaul of the custody rules applicable to custody banks, as envisaged by the Proposed Rule. For reasons that are unclear, the Proposed Rule neither considers nor accommodates the bank custody model.”

To learn more about the trades’ objections to the proposed rule, click here.

FDIC Proposes Special Assessment on Banks in Wake of SVB

The FDIC this week issued a proposed rule to impose a special assessment on the banking industry. The FDIC is aiming to recoup costs after policymakers invoked the systemic risk exception to guarantee SVB and Signature Bank’s uninsured depositors when the banks failed. The agency estimated the DIF losses at $15.8 billion, a decrease from the April estimate of $19.2 billion. Under the proposal, the special assessment would be imposed at an annual rate of 12.5 basis points on a bank’s total amount of uninsured deposits as of Dec. 31, 2022, after excluding the first $5 billion.

Timeline: The payments would be collected over eight quarters starting in the first quarter of 2024, with the first payment due in June 2024.
Which banks: 113 banks would contribute to the assessment. No bank with under $5 billion in assets would pay special assessments.

California SVB Report Does Not Blame Tailoring for Failure

The California Department of Financial Protection and Innovation (DFPI) this week issued a review of its oversight and regulation of SVB. The DFPI, along with the Federal Reserve Bank of San Francisco, supervised SVB prior to its failure. Some themes and key findings in the review are set out below:CaliforniaSVB Report Does Not Blame Tailoring or a More Permissive Supervisory Culture for Failure

Unlike the Fed report on SVB released on April 28, the California report does not point to regulatory tailoring as a possible contributing factor to SVB’s failure.
In addition, unlike the Fed report, the California report does not point to a shift in the stance of supervisory policy – or a more lenient supervisory culture – as contributing to slow identification and remediation of risk management weaknesses at SVB.

The California SVB Report Emphasizes the Fed’s Role as Lead Examiner on Liquidity and Interest Rate Risk

The report de-emphasizes the DFPI’s role as examiner in several areas that ultimately led to SVB’s failure. The dedicated DFPI examination team did not develop SVB’s examination plan but rather relied on the Fed’s examination plans.
The regulator only had two examiners dedicated to SVB full time and 12 other examiners dedicated part time to SVB examination matters.
The report notes that supervisors flagged concerns with SVB’s interest rate risk management and risk governance frameworks. At the same time, DFPI finds that supervisors did not take timely steps to ensure that SVB remediated known deficiencies fast enough or appreciate novel risks presented by SVB’s uninsured deposit levels and tech industry concentration.

Findings and Efforts to Improve California DFPI Supervision Going Forward

DFPI plans to work with federal partners such as the Fed on tighter turnaround times for MRAs.
DFPI will employ heightened scrutiny for large banks with large uninsured deposit concentrations (e.g., by monitoring key indicators such as banks’ concentration of uninsured deposits by industry). The DFPI will also update its training procedures and exam manuals to emphasize risks from uninsured deposits.
Going forward, bank management subject to DFPI supervision will be required to explain how it is monitoring social media and addressing/testing for reputational risks. In addition, management will need to quantify these new risks associated with new technology.
DFPI will “review internal staffing processes … for banks with assets above $50 billion commensurate with accelerated institution growth or increased risk profile”.

BPI’s Nelson Discusses What Caused SVB Failure – and What Didn’t – at AEI Event

BPI Chief Economist Bill Nelson this week participated in a panel discussion on recent bank failures hosted by the American Enterprise Institute. Nelson laid out the causes of SVB’s failure – significant lapses in supervision and bank risk management – and the factors that did not cause it, but that have attracted blame from the Fed’s recent SVB report. “SVB’s failure was not caused by a lax supervisory culture or the tailoring of regulations,” Nelson said.

Tailoring: Nelson outlined how regulatory requirements, absent the tailoring law, would have affected SVB – the capital and liquidity rules under the non-tailoring framework would not have prevented the bank’s collapse, he said.
Wrong target: He also noted that the SVB report spearheaded by Vice Chair for Supervision Michael Barr took unfair aim at Barr’s predecessor: “There’s an old joke about an outgoing president giving an incoming president three envelopes to open when he encounters some difficulties,” Nelson said. “The Barr report effectively combined the first two envelopes, which are blaming your predecessor, and then blame the Fed. Notably, the last envelope is ‘prepare three envelopes.’” Nelson observed that supervisors were “plenty assertive – it’s just they weren’t assertive about the right things.”
Other topics: Nelson also discussed ways in which the Fed’s lender of last resort function could have worked better during SVB’s collapse, and how the Fed’s monetary policy actions may have contributed to recent stresses.

The panel also featured Columbia University professor Charles Calomiris, Dartmouth College professor Andrew Levin and Mises Institute senior fellow Alex Pollock. Watch a recording of the event here.

The Crypto Ledger

A former Coinbase employee was sentenced to two years in prison in the first crypto insider-trading case. Bittrex, a crypto platform facing SEC scrutiny, filed for bankruptcy after its U.S. operations were shut down. And Sam Bankman-Fried, the disgraced founder of FTX, unveiled his first detailed legal defense this week, which accused the firm and its lawyers of forcing Bankman-Fried to step down as CEO.

Recommended read: For those who care to know what is actually going on in crypto (and we are not saying anyone should), reading Molly White’s work is an absolute requirement. Witness her latest note, which is an annotated takedown of the most recent State of Crypto Report from Andreessen Horowitz and is the kind of work we esteem at BPI: detailed, unflinching and at times funny.
Binance looks to Britain: Regulatory crackdowns have made it “very difficult” to do business in the U.S., according to Binance, which faces multiple major probes in the country. Binance will do “everything we possibly can” to be regulated in the U.K., the company’s chief strategy officer said at a Financial Times conference.
Miami sours on crypto: “Miami’s love affair with crypto is souring as bitcoin faithful flock to the city,” a recent Wall Street Journal headline reads.

‘Fifth Third Day’ on 5/3 Aims to Reduce Food Insecurity

Fifth Third Bank celebrated “Fifth Third Day” on May 3 (5/3) by combating food insecurity in the communities it serves. The bank provided 10 million meals across its 11-state retail footprint. The bank has recognized 5/3 since 1991 with themed community support initiatives.